Back to GetFilings.com
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
---------
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2004
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition period from____ to_____
Commission file number 1-14161
KEYSPAN CORPORATION
-------------------
(Exact name of Registrant as specified in its Charter)
New York 11-3431358
-------- ----------
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
One MetroTech Center, Brooklyn, New York 11201
175 East Old Country Road, Hicksville, New York 11801
----------------------------------------------------------
(Address of principal executive offices) (Zip Code)
(718) 403-1000 (Brooklyn)
(631) 755-6650 (Hicksville)
---------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.[X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).[X}
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class of Common Stock Outstanding at October 13, 2004
--------------------- -------------------------------
$.01 par value 160,595,889
KEYSPAN CORPORATION AND SUBSIDIARIES
INDEX
-----
Part I. FINANCIAL INFORMATION Page No.
--------
Item 1. Financial Statements
Consolidated Balance Sheet -
September 30, 2004 and December 31, 2003 3
Consolidated Statement of Income - Three and
Nine Months Ended September 30, 2004 and 2003 5
Consolidated Statement of Cash Flows -
Nine Months Ended June 30, 2004 and 2003 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 38
Item 3. Quantitative and Qualitative Disclosures
About Market Risk 71
Item 4. Controls and Procedures 74
Part II. OTHER INFORMATION
Item 1. Legal Proceedings 75
Item 6. Exhibits 75
Signatures 76
2
CONSOLIDATED BALANCE SHEET
(Unaudited)
- --------------------------------------------------------------------------------------------------------------------------
(In Thousands of Dollars) September 30, 2004 December 31, 2003
- --------------------------------------------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash and temporary cash investments $ 361,297 $ 205,751
Accounts receivable 806,489 1,029,459
Unbilled revenue 212,630 505,633
Allowance for uncollectible accounts (66,873) (79,184)
Gas in storage and prepaid gas 564,630 488,521
Material and supplies, at average cost 117,913 121,415
Other 84,976 115,304
-------------------------------- ----------------------------
2,081,062 2,386,899
-------------------------------- ----------------------------
Investments and Other 516,604 248,565
Property
Gas 6,790,147 6,522,251
Electric 2,356,169 2,636,537
Other 433,823 425,576
Accumulated depreciation (2,709,225) (2,610,876)
Gas exploration and production, at cost 182,114 3,088,242
Accumulated depletion (103,867) (1,167,427)
-------------------------------- ----------------------------
6,949,161 8,894,303
-------------------------------- ----------------------------
Deferred Charges
Regulatory assets 530,705 578,383
Goodwill and other intangible assets 1,688,287 1,809,712
Other 775,754 722,320
-------------------------------- ----------------------------
2,994,746 3,110,415
-------------------------------- ----------------------------
Total Assets $ 12,541,573 $ 14,640,182
================================ ============================
See accompanying Notes to the Consolidated Financial Statements.
3
CONSOLIDATED BALANCE SHEET
(Unaudited)
- --------------------------------------------------------------------------------------------------------------------------------
(In Thousands of Dollars) September 30, 2004 December 31, 2003
- --------------------------------------------------------------------------------------------------------------------------------
LIABILITIES AND CAPITALIZATION
Current Liabilities
Current redemption of long-term debt $ 16,142 $ 1,471
Accounts payable and other liabilities 662,127 1,141,597
Commercial paper 575,375 481,900
Dividends payable 72,248 72,289
Taxes accrued 43,474 46,580
Customer deposits 43,565 40,370
Interest accrued 77,493 64,609
----------------------------------- -----------------------------
1,490,424 1,848,816
----------------------------------- -----------------------------
Deferred Credits and Other Liabilities
Regulatory liabilities:
Miscellaneous liabilities 154,059 104,034
Removal cost recovered 485,394 450,034
Deferred income tax 1,091,443 1,278,341
Postretirement benefits and other reserves 951,889 961,962
Other 113,683 121,790
----------------------------------- -----------------------------
2,796,468 2,916,161
----------------------------------- -----------------------------
Commitments and Contingencies (See Note 6) - -
Capitalization
Common stock 3,495,111 3,487,645
Retained earnings 665,823 621,430
Accumulated other comprehensive loss (66,537) (59,932)
Treasury stock (354,165) (378,487)
----------------------------------- -----------------------------
Total common shareholders' equity 3,740,232 3,670,656
Preferred stock 75,000 83,568
Long-term debt 4,423,862 5,611,432
----------------------------------- -----------------------------
Total Capitalization 8,239,094 9,365,656
----------------------------------- -----------------------------
Minority Interest in Subsidiary Companies 15,587 509,549
----------------------------------- -----------------------------
Total Liabilities and Capitalization $ 12,541,573 $ 14,640,182
=================================== =============================
See accompanying Notes to the Consolidated Financial Statements.
4
CONSOLIDATED STATEMENT OF INCOME
(Unaudited)
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Thousands of Dollars, Except Per Share Amounts) 2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues
Gas Distribution $ 419,208 $ 405,777 $ 3,023,350 $ 2,970,514
Electric Services 503,879 438,577 1,296,778 1,228,622
Energy Services 118,580 137,961 377,516 399,294
Energy Investments 8,767 149,499 314,134 454,061
------------------------------------------------------------------------------------
Total Revenues 1,050,434 1,131,814 5,011,778 5,052,491
------------------------------------------------------------------------------------
Operating Expenses
Purchased gas for resale 186,619 172,452 1,776,322 1,792,917
Fuel and purchased power 176,028 133,313 407,987 333,311
Operations and maintenance 434,874 507,381 1,404,835 1,515,206
Depreciation, depletion and
amortization 93,420 135,656 454,737 422,917
Goodwill impairment charge 122,229 - 122,229 -
Operating taxes 89,525 91,790 302,143 311,754
------------------------------------------------------------------------------------
Total Operating Expenses 1,102,695 1,040,592 4,468,253 4,376,105
------------------------------------------------------------------------------------
Gain on sale of long lived asset - 13,974 - 13,974
Income from Equity Investments 16,213 2,727 30,342 12,486
------------------------------------------------------------------------------------
Operating Income (Loss) (36,048) 107,923 573,867 702,846
------------------------------------------------------------------------------------
Other Income and (Deductions)
Interest charges (88,308) (78,366) (260,848) (226,503)
Gain (loss) on subsidiary stock
transactions - - 172,894 (11,325)
Cost of debt redemption (45,879) - (45,879) (24,094)
Minority interest (58) (19,894) (37,012) (50,252)
Other 4,204 10,325 26,418 24,779
------------------------------------------------------------------------------------
Total Other Income and (Deductions) (130,041) (87,935) (144,427) (287,395)
------------------------------------------------------------------------------------
Income Taxes
Current (176,828) (39,317) (13,330) 94,275
Deferred 126,518 46,720 180,115 71,439
------------------------------------------------------------------------------------
Total Income Taxes (50,310) 7,403 166,785 165,714
------------------------------------------------------------------------------------
Earnings (Loss) Before Change in Accounting
Principle (115,779) 12,585 262,655 249,738
Cummulative Change in Accounting Principle - - - 174
------------------------------------------------------------------------------------
Net Income (Loss) (115,779) 12,585 262,655 249,912
Preferred stock dividend requirements 1,360 1,461 4,280 4,383
------------------------------------------------------------------------------------
Earnings (Loss) for Common Stock $ (117,139) $ 11,124 $ 258,375 $ 245,529
====================================================================================
Basic Earnings (Loss) Per Share:
Before Change in Accounting Principle (0.73) 0.07 1.61 1.56
Change in Accounting Principle - - - -
------------------------------------------------------------------------------------
Basic Earnings (Loss) Per Share $ (0.73) $ 0.07 $ 1.61 $ 1.56
====================================================================================
Diluted Earnings (Loss) Per Share:
Before Change in Accounting Principle (0.73) 0.07 1.60 1.55
Change in Accounting Principle - - - -
------------------------------------------------------------------------------------
Diluted Earnings (Loss) Per Share $ (0.73) $ 0.07 $ 1.60 $ 1.55
====================================================================================
Average Common Shares Outstanding (000) 160,357 158,783 160,139 157,871
Average Common Shares Outstanding - Diluted (000) 161,346 159,539 161,091 158,670
See accompanying Notes to the Consolidated Financial Statements.
5
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)
- ------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003
- ------------------------------------------------------------------------------------------------------------------------
Operating Activities
Net income $ 262,655 $ 249,912
Adjustments to reconcile net income to net
cash provided by (used in) operating activities
Depreciation, depletion and amortization 454,736 422,917
Deferred income tax 31,517 71,439
Income from equity investments (30,342) (12,486)
Dividends from equity investments 3,970 1,021
Amortization of interest rate swaps 182 (7,396)
Gain (Loss) on subsidiary stock transactions (172,894) 11,325
Gain (Loss) on sale of property - (13,974)
(Gain) on settlement of treasury lock (12,656) -
Goodwill impairment charge 122,229 -
Amortization of prepayments 74,557 62,945
Minority interest 37,012 50,252
Changes in assets and liabilities
Accounts receivable 301,011 384,836
Materials and supplies, fuel oil and gas in storage (80,072) (239,847)
Accounts payable and other liabilities (235,171) (114,589)
Interest accrued 12,884 22,161
Captive insurance reserve 43,214 -
Property tax prepayments (55,413) (86,631)
Other 23,915 (45,211)
-------------------------------------------
Net Cash Provided by Operating Activities 781,334 756,674
-------------------------------------------
Investing Activities
Construction expenditures (563,207) (720,217)
Other investments - (50,500)
Cost of removal (21,249) (19,611)
Proceeds from sale of property 13,138 13,974
Net proceeds from sale/leaseback transaction 383,716 -
Net proceeds from subsidiary stock transactions 512,065 198,553
-------------------------------------------
Net Cash Provided by (Used In) Investing Activities 324,463 (577,801)
-------------------------------------------
Financing Activities
Treasury stock issued 24,322 76,984
Equity issuance - 473,573
Issuance of long-term debt 49,336 710,475
Payment of long-term debt (920,033) (564,506)
Issuance (Payment) of commercial paper 93,475 (271,297)
Redemption of promissory notes - (447,005)
Gain on settlement of treasury lock 12,656 -
Redemption of preferred stock (8,483) (14,293)
Preferred stock dividends paid (4,280) (4,383)
Common stock dividends paid (214,075) (203,795)
Other 16,831 12,808
-------------------------------------------
Net Cash (Used in) Financing Activities (950,251) (231,439)
-------------------------------------------
Net Increase in Cash and Cash Equivalents $ 155,546 $ (52,566)
Cash and Cash Equivalents at Beginning of Period 205,751 170,617
-------------------------------------------
Cash and Cash Equivalents at End of Period $ 361,297 $ 118,051
===========================================
Cash equivalents are short-term marketable securities purchased with maturities
of six months or less that were carried at cost which approximates fair value.
See accompanying Notes to the Consolidated Financial Statements.
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
KeySpan Corporation (referred to in the Notes to the Financial Statements as
"KeySpan," "we," "us" and "our") is a registered holding company under the
Public Utility Holding Company Act of 1935, as amended ("PUHCA"). KeySpan
operates six regulated utilities that distribute natural gas to approximately
2.5 million customers in New York City, Long Island, Massachusetts and New
Hampshire, making KeySpan the fifth largest gas distribution company in the
United States and the largest in the Northeast. We also own and operate electric
generating plants in Nassau and Suffolk Counties on Long Island and in Queens
County in New York City and are the largest independent electric generation
operator in New York State. Under contractual arrangements, we provide power,
electric transmission and distribution services, billing and other customer
services for approximately 1.1 million electric customers of the Long Island
Power Authority ("LIPA"). KeySpan's other subsidiaries are involved in gas and
oil exploration and production; underground gas storage; liquefied natural gas
storage; retail electric marketing; appliance service; plumbing; heating,
ventilation and air conditioning and other mechanical services; large
energy-system ownership, installation and management; and engineering and
consulting services. We also invest and participate in the development of
natural gas pipelines, electric generation and other energy-related projects.
(See Note 2 "Business Segments" for additional information on each operating
segment.)
1. BASIS OF PRESENTATION
In our opinion, the accompanying unaudited Consolidated Financial Statements
contain all adjustments necessary to present fairly KeySpan's financial position
as of September 30, 2004, and the results of operations for the three and nine
months ended September 30, 2004 and September 30, 2003, as well as cash flows
for the nine months ended September 30, 2004 and September 30, 2003. The
accompanying financial statements should be read in conjunction with the
consolidated financial statements and notes included in KeySpan's Annual Report
on Form 10-K for the year ended December 31, 2003. The December 31, 2003
financial statement information has been derived from the 2003 audited financial
statements. Income from interim periods may not be indicative of future results.
Certain reclassifications were made to conform prior period financial statements
to the current period financial statement presentation.
Consolidated earnings are seasonal in nature primarily due to the significant
contribution to earnings of the gas distribution operations. As a result, we
expect to earn most of our annual earnings in the first and fourth quarters of
the fiscal year.
Basic earnings per share ("EPS") is calculated by dividing earnings available
for common stock by the weighted average number of shares of common stock
outstanding during the period. No dilution for any potentially dilutive
securities is included. Diluted EPS assumes the conversion of all potentially
dilutive securities and is calculated by dividing earnings available for common
stock, as adjusted, by the sum of the weighted average number of shares of
common stock outstanding plus all potentially dilutive securities.
7
We have approximately 3.5 million common stock options outstanding at September
30, 2004, that were not included in the calculation of diluted EPS since the
exercise price associated with these options was greater than the average market
price of our common stock.
Under the requirements of Statement of Financial Accounting Standards ("SFAS")
No. 128, "Earnings Per Share" our basic and diluted EPS are as follows:
- -----------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Thousands of Dollars, Except Per Share Amounts) 2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------------------------
Earnings (loss) for common stock $ (117,139) $ 11,124 $ 258,375 $ 245,529
Houston Exploration dilution - (74) - (212)
- -----------------------------------------------------------------------------------------------------------------------------------
Earnings (loss) for common stock - adjusted $ (117,139) $ 11,050 $ 258,375 $ 245,317
- -----------------------------------------------------------------------------------------------------------------------------------
Weighted average shares outstanding (000) 160,357 158,783 160,139 157,871
Add dilutive securities:
Options 989 - 952 -
Convertible preferred stock - 756 - 799
- -----------------------------------------------------------------------------------------------------------------------------------
Total weighted average shares outstanding - assuming dilution 161,346 159,539 161,091 158,670
- -----------------------------------------------------------------------------------------------------------------------------------
Basic earnings (loss )per share $ (0.73) $ 0.07 $ 1.61 $ 1.56
- -----------------------------------------------------------------------------------------------------------------------------------
Diluted earnings (loss) per share $ (0.73) $ 0.07 $ 1.60 $ 1.55
- -----------------------------------------------------------------------------------------------------------------------------------
2. BUSINESS SEGMENTS
We have four reportable segments: Gas Distribution, Electric Services, Energy
Services and Energy Investments.
The Gas Distribution segment consists of six gas distribution subsidiaries.
KeySpan Energy Delivery New York ("KEDNY") provides gas distribution services to
customers in the New York City Boroughs of Brooklyn, Queens and Staten Island.
KeySpan Energy Delivery Long Island ("KEDLI") provides gas distribution services
to customers in the Long Island Counties of Nassau and Suffolk and the Rockaway
Peninsula of Queens County. The remaining gas distribution subsidiaries, Boston
Gas Company, Colonial Gas Company, Essex Gas Company and EnergyNorth Natural
Gas, Inc., collectively referred to as KeySpan Energy Delivery New England
("KEDNE"), provide gas distribution service to customers in Massachusetts and
New Hampshire.
The Electric Services segment consists of subsidiaries that: operate the
electric transmission and distribution system owned by LIPA; own and provide
capacity to and produce energy for LIPA from our generating facilities located
on Long Island; and manage fuel supplies for LIPA to fuel our Long Island
generating facilities. These services are provided in accordance with long-term
service contracts having remaining terms that range from four to nine years and
power purchase agreements having remaining terms that range from nine years to
23 years. The Electric Services segment also includes subsidiaries that own or
lease and operate the 2,450 megawatt ("MW") Ravenswood electric generation
facility ("Ravenswood Facility"), located in Queens, New York, which includes
the recently completed 250 MW combined-cycle electric generating unit located at
the Ravenswood site ("Ravenswood Expansion"). Collectively the Ravenswood
Facility and the Ravenswood Expansion are referred to herein as the "Ravenswood
Projects." All of the energy, capacity and ancillary services related to the
8
Ravenswood Projects is sold to the New York Independent System Operator
("NYISO") energy markets. The Electric Services segment also conducts retail
marketing of electricity to commercial customers.
The Energy Services segment includes companies that provide energy-related
services to customers primarily located within the Northeastern United States,
with concentrations in the New York City metropolitan area, including New
Jersey, as well as Rhode Island, Pennsylvania, Massachusetts and New Hampshire,
through the following two lines of business: (i) Home Energy Services, which
provides residential and small commercial customers with service and maintenance
of energy systems and appliances; and (ii) Business Solutions, which provides
plumbing, heating, ventilation, air conditioning and mechanical services, as
well as operation and maintenance, design, engineering and consulting services
to commercial and industrial customers. In the third quarter of 2004, KeySpan
recorded a $122.2 million non-cash goodwill impairment charge in this segment.
See Note 12 "Goodwill Impairment" for further information regarding this charge.
The Energy Investments segment consists of our gas exploration and production
investments, as well as certain other domestic and international energy-related
investments. Our gas exploration and production subsidiaries are engaged in gas
and oil exploration and production, and the development and acquisition of
domestic natural gas and oil properties. These investments include our
approximate 23.5% interest in The Houston Exploration Company ("Houston
Exploration") an independent natural gas and oil exploration company, as well as
our wholly-owned subsidiaries Seneca-Upshur Petroleum, Inc. ("Seneca-Upshur")
and KeySpan Exploration and Production, LLC ("KeySpan Exploration and
Production"), which is engaged in a joint venture with Houston Exploration.
In June 2004, KeySpan exchanged 10.8 million shares of common stock of Houston
Exploration for 100% of the stock of Seneca-Upshur, previously a wholly owned
subsidiary of Houston Exploration. This transaction reduced our interest in
Houston Exploration from 55% to the current level of approximately 23.5%. As
part of this transaction, Houston Exploration retired 4.6 million of its common
shares and issued 6.8 million new shares in a public offering. Based on Houston
Exploration's announced offering price of $48.00 per share, Seneca-Upshur's
shares were valued at the equivalent of $449 million, or $41.57 per share.
Seneca-Upshur's assets consisted of West Virginia gas producing properties
valued at $60 million, and $389 million in cash. This transaction resulted in a
gain to KeySpan of $150.1 million. Effective June 1, 2004, Houston Exploration's
earnings and our ownership interest in Houston Exploration have been accounted
for on the equity basis of accounting. The deconsolidation of Houston
Exploration required the recognition of certain deferred taxes on our remaining
investment resulting in a net deferred tax expense of $44.1 million. Therefore,
the net gain on the share exchange less the deferred tax provision was $106
million, or $0.66 per share. It should be noted that in the second quarter of
2004, KeySpan recorded a $48.2 million non-cash impairment charge to recognize
the reduced valuation of proved reserves. See Note 10 "Gas Exploration and
Production Property - Depletion for further information on this charge.
9
Subsidiaries in this segment also hold a 17.4% ownership interest in KeySpan
Canada, a subsidiary with natural gas processing plants and gathering facilities
in Western Canada. In April 2004, KeySpan and KeySpan Facilities Income Fund
(the "Fund"), which previously owned a 39.09% interest in KeySpan Canada,
consummated a transaction whereby the Fund sold 15.617 million units of the Fund
at a price of CDN$12.60 per unit for gross total proceeds of approximately
CDN$196.8 million. The proceeds of the offering were used by the Fund to acquire
an additional 35.91% interest in KeySpan Canada from KeySpan. We received net
proceeds of approximately CDN$186.3 million (or approximately US$135 million),
after commissions and expenses. The Fund's ownership in KeySpan Canada increased
from 39.1% to 75%, and KeySpan's ownership of KeySpan Canada decreased to 25%.
KeySpan recorded a gain of $22.8 million ($10.1 million after-tax, or $0.06 per
share) on this transaction. Effective April 1, 2004 KeySpan Canada's earnings
and our ownership interest in KeySpan Canada have been accounted for on the
equity basis of accounting.
In July 2004, the Fund issued an additional 10.7 million units, the proceeds of
which were used to fund the acquisition of the midstream assets of Chevron
Canada Midstream Inc. This transaction had the effect of further diluting
KeySpan's ownership of KeySpan Canada to 17.4%.
This segment is also engaged in pipeline development activities. KeySpan and
Duke Energy Corporation each own a 50% interest in Islander East Pipeline
Company, LLC ("Islander East"). Islander East was created to pursue the
authorization and construction of an interstate pipeline from Connecticut,
across Long Island Sound, to a terminus near Shoreham, Long Island. Once in
service, the pipeline is expected to transport up to 260,000 DTH daily to the
Long Island and New York City energy markets. Further, in August 2004, KeySpan
acquired a 21% interest in the Millennium Pipeline project which will transport
up to 500,000 DTH of natural gas a day from Corning to Ramapo, New York, where
it will connect to an existing pipeline.
Additionally, subsidiaries in this segment hold a 20% equity interest in the
Iroquois Gas Transmission System LP, a pipeline that transports Canadian gas
supply to markets in the Northeastern United States and the KeySpan LNG facility
in Providence, Rhode Island, a 600,000 barrel liquefied natural gas storage and
receiving facility. Further, this segment has a 50% interest in the Premier
Transmission Pipeline in Northern Ireland.
The accounting policies of the segments are the same as those used for the
preparation of the Consolidated Financial Statements. The segments are strategic
business units that are managed separately because of their different operating
and regulatory environments. Operating results of our segments are evaluated by
management on an operating income basis. As a result of the Houston Exploration
stock transaction and the related deconsolidation, the total assets associated
with our gas exploration and production operations, including cash from the
transaction, were $650 million at September 30, 2004, compared to $1.5 billion
at December 31, 2003. Due to the KeySpan Canada transaction, total assets
associated with KeySpan's other energy-related investments were approximately
$607 million at September 30, 2004 compared to $900 million at December 31,
2003.
10
To better align the subsidiaries within our segments, we reclassified the
operating results of our electric marketing subsidiary from the Energy Services
segment to the Electric Services segment in the first quarter of 2004. As a
result we reclassified the financial results for all periods of 2003. The
revised reportable segment information is as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
Energy Investments
-----------------------------
Gas
Gas Electric Energy Exploration Other
(In Thousands of Dollars) Distribution Services Services and Production Investments Eliminations Consolidated
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended Sept. 30, 2004
Unaffiliated revenue 419,208 503,879 118,580 4,975 3,792 - 1,050,434
Intersegment revenue - - 7,172 - 1,274 (8,446) -
Operating income (Loss) (23,627) 111,158 (142,976) 12,332 4,102 2,963 (36,048)
Three Months Ended Sept. 30, 2003
Unaffiliated revenue 405,777 438,577 137,961 123,052 26,447 - 1,131,814
Intersegment revenue - 25 1,926 - 1,252 (3,203) -
Operating income (Loss) (25,134) 102,125 (15,498) 50,995 8,009 (12,574) 107,923
- ------------------------------------------------------------------------------------------------------------------------------------
Eliminating items include intercompany interest income and expense, the
elimination of certain intercompany accounts, as well as activities of our
corporate and administrative areas
Because of the nature of our Electric Services business, electric revenues are
derived from two large customers - the NYISO and LIPA. Electric Services
revenues from these customers for the three months ended September 30, 2004 and
2003 represent approximately 45% and 38%, respectively of our consolidated
revenues in both periods.
- ------------------------------------------------------------------------------------------------------------------------------------
Energy Investments
---------------------------
Gas
Gas Electric Energy Exploration Other
(In Thousands of Dollars) Distribution Services Services and Production Investments Eliminations Consolidated
- ------------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended Sept. 30, 2004
Unaffiliated revenue 3,023,350 1,296,778 377,516 276,320 37,814 - 5,011,778
Intersegment revenue - - 14,755 - 3,817 (18,572) -
Operating income (Loss) 391,090 226,273 (166,356) 85,828 22,473 14,559 573,867
Nine Months Ended Sept. 30, 2003
Unaffiliated revenue 2,970,514 1,228,622 399,294 373,774 80,287 - 5,052,491
Intersegment revenue - 76 4,894 - 3,756 (8,726) -
Operating income (Loss) 371,420 193,869 (35,083) 156,733 27,207 (11,300) 702,846
- ------------------------------------------------------------------------------------------------------------------------------------
Eliminating items include intercompany interest income and expense, the
elimination of certain intercompany accounts, as well as activities of our
corporate and administrative areas.
Because of the nature of our Electric Services business, electric revenues are
derived from two large customers - the NYISO and LIPA. Electric Services
revenues from these customers for the nine months ended September 30, 2004 and
2003 represent approximately 25% and 22%, respectively of our consolidated
revenues for both periods.
11
3. COMPREHENSIVE INCOME
The table below indicates the components of comprehensive income:
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended Sept. 30, Nine Months Ended Sept. 30,
(In Thousands of Dollars) 2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Earnings (loss) for common stock $ (117,139) $ 11,124 $ 258,375 $ 245,529
- ------------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income (loss), net of tax
Reclassification adjustments for loss (gains) realized in
net income (13,945) 8,431 2,586 19,602
Foreign currency translation adjustments 576 366 (16,487) 27,892
Unrealized gains (losses) on marketable securities (1,259) 1,209 (717) 3,458
Premiums on derivative financial instruments - - 3,437 (3,437)
Deconsolidation of certain subsidiaries - - (6,711) -
Unrealized gain (losses) on derivative financial instruments 12,461 13,740 11,288 (7,193)
- ------------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income (loss), net of tax (2,167) 23,746 (6,604) 40,322
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive Income $ (119,306) $ 34,870 $ 251,771 $ 285,851
- ------------------------------------------------------------------------------------------------------------------------------------
Related tax (benefit) expense
Reclassification adjustments for loss (gains) realized in
net income (8,623) 4,540 279 10,555
Foreign currency translation adjustments 310 197 (8,878) 15,019
Unrealized gains (losses) on marketable securities (955) 652 (665) 1,863
Premiums on derivative financial instruments - - 1,851 (1,851)
Deconsolidation of certain subsidiaries - - 5,016
Unrealized gain (losses) on derivative financial instruments 8,101 7,398 7,470 (3,873)
- ------------------------------------------------------------------------------------------------------------------------------------
Total Tax (Benefit) Expense $ (1,167) $ 12,787 $ 5,073 $ 21,713
- ------------------------------------------------------------------------------------------------------------------------------------
4. HEDGING AND DERIVATIVE FINANCIAL INSTRUMENTS
Financially-Settled Commodity Derivative Instruments - Hedging Activities: From
time to time, KeySpan subsidiaries have utilized derivative financial
instruments, such as futures, options and swaps, for the purpose of hedging the
cash flow variability associated with changes in commodity prices. KeySpan is
exposed to commodity price risk primarily with regard to its gas distribution
operations, gas exploration and production activities and its electric
generating facilities at the Ravenswood site.
Derivative financial instruments are employed by our gas distribution operations
to reduce the cash flow variability associated with the purchase price for a
portion of future natural gas purchases for our regulated firm gas sales
customers. The accounting for these derivative instruments is subject to SFAS 71
"Accounting for the Effects of Certain Types of Regulation." See the caption
below "Firm Gas Sales Derivative Instruments - Regulated Utilities" for a
further discussion of these derivatives. Certain derivative instruments employed
by our gas distribution operations are not subject to SFAS 71. Utility tariffs
applicable to certain large-volume customers permit gas to be sold at prices
established monthly within a specified range expressed as a percentage of
prevailing alternate fuel oil prices. KEDNY uses natural gas swap contracts,
with offsetting positions in fuel oil swap contracts of equivalent energy value,
to hedge the cash-flow variability of specified portions of gas purchases and
12
sales associated with these customers. The maximum length of time over which we
have hedged cash flow variability associated with forecasted purchases and sales
of natural gas and fuel oil is through February 2005. We use standard New York
Mercantile Exchange ("NYMEX") futures prices to value the gas futures contracts
and market quoted forward prices to value oil swap contracts. The fair market
value of these derivative instruments at September 30, 2004 was a liability of
$1.4 million, all of which is expected to be reclassified from other
comprehensive income into earnings over the next twelve months.
Seneca-Upshur utilizes over-the-counter ("OTC") natural gas index swaps to hedge
the cash flow variability associated with forecasted sales of a portion of its
natural gas production. At September 30, 2004, Seneca-Upshur has hedge positions
in place for approximately 85% of its estimated remaining 2004 gas production,
net of gathering related costs. Further, Seneca-Upshur has hedge positions in
place for approximately 85% of its estimated 2005 through 2007 gas production,
net of gathering costs. We use forward index prices to value these swap
positions. The maximum length of time over which Seneca-Upshur has hedged such
cash flow variability is through December 2007. The fair market value of these
derivative instruments at September 30, 2004 was a liability of $2.0 million.
The estimated amount of losses associated with such derivative instruments that
are reported in other comprehensive income and that are expected to be
reclassified into earnings over the next twelve months is $1.4 million, or
approximately $0.9 million after-tax.
Derivative financial instruments are employed by Houston Exploration to hedge
cash flow variability associated with forecasted sales of natural gas. Since
Houston Exploration is no longer a consolidated subsidiary, the fair market
value of their outstanding derivative instruments are not reflected on KeySpan's
September 30, 2004 Consolidated Balance Sheet.
The Ravenswood Projects use derivative financial instruments to hedge the cash
flow variability associated with the purchase of natural gas and oil that will
be consumed during the generation of electricity. The Ravenswood Projects also
hedge the cash flow variability associated with a portion of on-peak electric
energy sales.
With respect to price exposure associated with fuel purchases for the Ravenswood
Projects, KeySpan employs standard NYMEX natural gas futures contracts to hedge
the cash flow variability for a portion of forecasted purchases of natural gas.
KeySpan also employs the use of financially-settled oil swap contracts to hedge
the cash flow variability for a portion of forecasted purchases of fuel oil that
will be consumed by the Ravenswood Projects. The maximum length of time over
which we have hedged cash flow variability associated with forecasted purchases
of natural gas is through September 2005. The maximum length of time over which
we have hedged cash flow variability associated with forecasted purchases of
fuel oil is through April 2006. We use standard NYMEX futures prices to value
the gas futures contracts and market quoted forward prices to value oil swap
contracts. The fair market value of these derivative instruments at September
30, 2004 was $0.5 million. A substantial portion of these derivative
instruments, which are reported in other comprehensive income, are expected to
be reclassified into earnings over the next twelve months.
13
We have also engaged in the use of cash-settled swap instruments to hedge the
cash flow variability associated with a portion of forecasted electric energy
sales from the Ravenswood Projects. Our hedging strategy is to hedge
approximately 50% of forecasted on-peak summer season electric energy sales and
a portion of forecasted electric energy sales for the remainder of the year. The
maximum length of time over which we have hedged cash flow variability is
through December 2005. We use market quoted forward prices to value these
outstanding derivatives. The fair market value of these derivative instruments
at September 30, 2004 was $2.3 million. The estimated amount of gains associated
with such derivative instruments that are reported in other comprehensive income
and that are expected to be reclassified into earnings over the next twelve
months is $2.1 million, or approximately $1.4 million after-tax.
The above noted derivative financial instruments are cash flow hedges that
qualify for hedge accounting under SFAS 133 "Accounting for Derivative
Instruments and Hedging Activities," as amended by SFAS 149 "Amendment of
Statement 133 on Derivative Instruments and Hedging Activities," collectively
SFAS 133, and are not considered held for trading purposes as defined by current
accounting literature. Accordingly, we carry the fair market value of our
derivative instruments on the Consolidated Balance Sheet as either a current or
deferred asset or liability, as appropriate, and defer the effective portion of
unrealized gains or losses in accumulated other comprehensive income. As noted,
the fair market value of Houston Exploration's outstanding derivative
instruments are not reflected on the September 30, 2004 Consolidated Balance
Sheet. Gains and losses are reclassified from accumulated other comprehensive
income to the Consolidated Statement of Income in the period the hedged
transaction affects earnings. Gains and losses are reflected as a component of
either revenue or fuel and purchased power depending on the hedged transaction.
Hedge ineffectiveness results from changes during the period in the price
differentials between the index price of the derivative contract and the index
price at the point of sale for the cash flow that is being hedged, and is
recorded directly to earnings.
The table below summarizes the fair value of outstanding financially-settled
commodity derivative instruments that qualify for hedge accounting at September
30, 2004 and the related line item on the Consolidated Balance Sheet. Fair value
is the amount at which derivative instruments could be exchanged in a current
transaction between willing parties, other than in a forced liquidation sale. As
noted earlier, derivative instruments employed by Houston Exploration are no
longer reflected on KeySpan's Consolidated Balance Sheet.
14
- ----------------------------------------------------------------------------------------------------------
(In Thousands of Dollars) September 30, 2004 December 31, 2003
- ----------------------------------------------------------------------------------------------------------
Gas Contracts:
Other current assets $ 5,318 $ 3,458
Accounts payable and other liabilities - (35,592)
Other deferred liabilities (606) (4,734)
Oil Contracts:
Other current assets 527 -
Accounts payable and other liabilities (8,060)
Other deferred charges 25 385
Electric Contracts:
Other current assets 2,083 -
Other deferred charges 194 259
- ----------------------------------------------------------------------------------------------------------
$ (519) $ (36,224)
- ----------------------------------------------------------------------------------------------------------
Financially-Settled Commodity Derivative Instruments that Do Not Qualify for
Hedge Accounting: KeySpan subsidiaries also have employed a limited number of
financial derivatives that do not qualify for hedge accounting treatment under
SFAS 133. In September 2004, we purchased a series of call options on the spread
between the price of heating oil and the price of natural gas. The options cover
the period September 2004 through February 2005 and further complement our
hedging strategy noted above regarding sales to certain large-volume customers.
As stated, we sell gas to certain large-volume customers at prices established
monthly within a specified range expressed as a percentage of prevailing
alternate fuel oil prices. Utility tariffs, however, establish an upper limit on
the price KeySpan can charge for the sale of natural gas to these customers.
These options are intended to limit KeySpan's exposure to heating oil price
spikes. These options do not qualify for hedge accounting treatment under SFAS
133. We recorded a $0.6 million charge in other income and deductions on the
Consolidated Statement of Income to reflect the change in the market value
associated with this derivative instrument.
Firm Gas Sales Derivative Instruments - Regulated Utilities: We use derivative
financial instruments to reduce the cash flow variability associated with the
purchase price for a portion of future natural gas purchases associated with our
Gas Distribution operations. Our strategy is to minimize fluctuations in firm
gas sales prices to our regulated firm gas sales customers in our New York and
New England service territories. The accounting for these derivative instruments
is subject to SFAS 71. Therefore, changes in the fair value of these derivatives
have been recorded as a regulatory asset or regulatory liability on the
Consolidated Balance Sheet. Gains or losses on the settlement of these contracts
are initially deferred and then refunded to or collected from our firm gas sales
customers consistent with regulatory requirements. At September 30, 2004, these
derivatives had a fair market value of $87.1 million and are reflected as a
regulatory liability on the Consolidated Balance Sheet.
Physically-Settled Commodity Derivative Instruments: SFAS 133 establishes
criteria that must be satisfied in order for option contracts, forward contracts
with optionality features, or contracts that combine a forward contract and a
purchase option contract to be exempted as normal purchases and sales. Based
upon a continuing review of our physical gas contracts, we determined that
certain contracts for the physical purchase of natural gas associated with our
regulated gas utilities are not exempt as normal purchases from the requirements
15
of SFAS 133. Since these contracts are for the purchase of natural gas sold to
regulated firm gas sales customers, the accounting for these contracts is
subject to SFAS 71. Therefore, changes in the market value of these contracts
have been recorded as a regulatory asset or regulatory liability on the
Consolidated Balance Sheet. At September 30, 2004, these derivatives had a fair
market value of $3.7 million and are reflected as a regulatory liability on the
Consolidated Balance Sheet.
Interest Rate Derivative Instruments: In May 2003, we entered into interest rate
swap agreements in which we swapped $250 million of 7.25% fixed rate debt to
floating rate debt. Under the terms of the agreements, we received the fixed
coupon rate associated with these bonds and paid our swap counterparties a
variable interest rate based on LIBOR, that was reset on a semi-annual basis.
These swaps were designated as fair-value hedges and qualified for "short-cut"
hedge accounting treatment under SFAS 133. In the first quarter of 2004, we paid
our counterparty an average interest rate of 6.44%, and as a result, we realized
interest savings of $0.5 million.
On April 7, 2004 we terminated these swap agreements and received $1.2 million
from our swap counterparties, of which $0.7 million represented accrued swap
interest. The difference between the termination settlement amount and the
amount of accrued interest, $0.5 million, was being recorded as a reduction to
interest expense over the remaining life of the bonds. In August 2004, we
redeemed these bonds and recorded the remaining benefit.
KeySpan has a leveraged lease financing arrangement associated with the
Ravenswood Expansion. In May 2004, the facility was acquired by a lessor from
our subsidiary, KeySpan Ravenswood, LLC, and simultaneously leased back to that
subsidiary. In connection with this sale/leaseback transaction, KeySpan utilized
a $275 million treasury lock (at 4.2%) to hedge the 10-year US Treasury
component of the underlying notes issued by the lessor to purchase the facility.
The treasury lock was in effect for a five-week period during which time the
10-year US Treasury increased 70 basis points. KeySpan did not designate this
derivative instrument as a hedge for accounting purposes. The treasury lock
settled in May 2004 and KeySpan received cash proceeds of $12.6 million which
was recorded in other income and (deductions) in the Consolidated Statement of
Income. (See Note 6. "Financial Guarantees and Contingencies" for additional
information regarding the sale/leaseback transaction.)
Weather Derivatives: The utility tariffs associated with KEDNE's operations do
not contain weather normalization adjustments. As a result, fluctuations from
normal weather may have a significant positive or negative effect on the results
of these operations.
In September 2004, we entered into heating-degree day put options to mitigate
the effect of fluctuations from normal weather on KEDNE's financial position and
cash flows for the 2004/2005 winter heating season - November 2004 through March
2005. These put options will pay KeySpan $40,000 per heating degree day when the
actual temperature is below 4,140 heating degree days, or approximately 5%
warmer than normal, based on the most recent 20-year average for normal weather.
The maximum amount KeySpan may receive on these purchased put options is $16
16
million. The net premium cost for these options was $1.6 million. Unlike
previous years (see below) if weather is colder than normal KeySpan will have no
financial obligation. We account for these derivatives pursuant to the
requirements of EITF 99-2, "Accounting for Weather Derivatives." In this regard,
such instruments are accounted for using the "intrinsic value method" as set
forth in such guidance.
In October 2003, KEDNE entered into heating-degree day call and put options for
the 2003/2004 winter heating season - November 2003 through March 2004. With
respect to sold call options, KeySpan was required to make a payment of $27,500
per heating degree day to its counterparties when actual weather experienced
during this time frame was above 4,440 heating degree days, which equates to
approximately 2% colder than normal weather, based on the then most recent
20-year average for normal weather. The maximum amount KeySpan was required to
pay on its sold call options was $5.5 million. With respect to purchased put
options, KeySpan would have received a $27,500 per heating degree day payment
from its counterparties when actual weather was below 4,266 heating degree days,
or approximately 2% warmer than normal. The maximum amount KeySpan would have
received on its purchased put options was $11 million. The net premium cost for
these options was $0.4 million. During the first quarter of 2004, weather, as
measured in heating degree-days, was 9.4% colder than normal and, as a result
$4.1 million was recorded as a reduction to revenues.
Derivative contracts are primarily used to manage exposure to market risk
arising from changes in commodity prices, interest rates and weather. In the
event of non-performance by a counterparty to a derivative contract, the desired
impact may not be achieved. The risk of counterparty non-performance is
generally considered a credit risk and is actively managed by assessing each
counterparty credit profile and negotiating appropriate levels of collateral and
credit support. We believe that our credit risk related to the above mentioned
derivative financial instruments is no greater than the risk associated with the
primary contracts which they hedge and that the elimination of a portion of the
price risk reduces volatility in our reported results of operations, financial
position and cash flows and lowers overall business risk.
5. RECENT ACCOUNTING PRONOUNCEMENTS
In May 2004, the Financial Accounting Standards Board ("FASB") issued FASB Staff
Position ("FSP") 106-2 "Accounting and Disclosure Requirements Related to the
Medicare Prescription Drug, Improvement and Modernization Act of 2003." This
guidance supersedes FSP 106-1 issued in January 2004 and clarifies the
accounting and disclosure requirements for employers with postretirement benefit
plans that have been or will be affected by the passage of the Medicare
Prescription Drug Improvement and Modernization Act of 2003 ("the Act"). The Act
introduces two new features to Medicare that an employer needs to consider in
measuring its obligation and net periodic postretirement benefit costs. The
effective date for the new requirements is the first interim or annual period
beginning after June 15, 2004.
17
KeySpan's retiree health benefit plan currently includes a prescription drug
benefit that is provided to retired employees. KeySpan implemented the
requirements of FSP 106-2 in September 2004 and determined that the savings
associated with the Act will reduce KeySpan's retiree health care costs by
approximately $10 million in 2004. However, KEDLI and Boston Gas Company are
subject to certain deferral accounting requirements mandated by the New York
State Public Service Commission ("NYPSC") and the Massachusetts Department of
Telecommunications and Energy ("MA DTE"), respectively for pension costs and
other postretirement benefit costs. Further, in accordance with our service
agreements with LIPA, variations between pension costs and other postretirement
benefit costs incurred by KeySpan compared to those costs recovered through
rates charged to LIPA are deferred subject to recovery from or refund to LIPA.
As a result of these various requirements, KeySpan estimates that approximately
$7 million of savings attributable to the implementation of FSP 106-2 and the
Act will be deferred and used to offset increases in overall pension and
postretirement benefit costs, with the remaining approximately $3 million
available to KeySpan. Therefore, in September 2004, KeySpan recorded
approximately $2.2 million as a reduction to its health care costs representing
nine months of the benefit. The implementation of FSP 106-2 and the Act had no
impact on KeySpan's cash flow.
6. FINANCIAL GUARANTEES AND CONTINGENCIES
Variable Interest Entity: KeySpan has an arrangement with a variable interest
entity through which we lease a portion of the Ravenswood Facility. We acquired
the Ravenswood Facility, then a 2,200-megawatt electric generating facility
located in Queens, New York, in part, through a variable interest entity from
Consolidated Edison Company of New York, Inc. ("Consolidated Edison") on June
18, 1999 for approximately $597 million. In order to reduce the initial cash
requirements, we entered into a lease arrangement ("Master Lease") with a
variable interest, unaffiliated financing entity that acquired a portion of the
facility, or six steam generating units, directly from Consolidated Edison and
leased it to our subsidiary. The variable interest unaffiliated financing entity
acquired the property for $425 million, financed with debt of $412.3 million
(97% of capitalization) and equity of $12.7 million (3% of capitalization).
KeySpan has no ownership interests in the units or the variable interest entity.
KeySpan has guaranteed all payment and performance obligations of our subsidiary
under the Master Lease. Monthly lease payments substantially equal the monthly
interest expense on such debt securities.
The initial term of the Master Lease expired on June 20, 2004 and was extended
until June 20, 2009 pursuant to the terms of the Master Lease. On all future
semi-annual payment dates, we have the option to: (i) either purchase the
facility for the original acquisition cost of $425 million, plus the present
value of the lease payments that would otherwise have been paid through June
2009; or (ii) terminate the Master Lease and dispose of the facility. In June
2009, when the Master Lease terminates, we may purchase the facility in an
amount equal to the original acquisition cost, subject to adjustment, or
surrender the facility to the lessor. If we elect not to purchase the property,
the Ravenswood Facility will be sold by the lessor. We have guaranteed to the
lessor 84% of the residual value of the original cost of the property.
18
We have classified the Master Lease as $412.3 million of long-term debt on the
Consolidated Balance Sheet based on our current status as primary beneficiary.
Further, we have an asset on the Consolidated Balance Sheet for an amount
substantially equal to the fair market value of the leased assets at the
inception of the lease, less depreciation since that date, or approximately $380
million. Under the terms of our two credit facilities, the Master Lease is
considered debt in the ratio of debt-to-total capitalization. If our subsidiary
that leases the Ravenswood Facility were not able to fulfill its payment
obligations with respect to the Master Lease payments, then the maximum amount
KeySpan would be exposed to under its current guarantees would be $425 million,
plus the present value of the remaining lease payments through June 20, 2009.
Sale/leaseback Transaction: KeySpan also has a leveraged lease financing
arrangement associated with the Ravenswood Expansion. In May 2004, the unit was
acquired by a lessor from our subsidiary, KeySpan Ravenswood, LLC, and
simultaneously leased back to that subsidiary. All the obligations of KeySpan
Ravenswood, LLC have been unconditionally guaranteed by KeySpan. This lease
transaction generated cash proceeds of $385 million, before transaction costs,
which approximates the fair market value of the facility, as determined by a
third-party appraiser. This lease transaction qualifies as an operating lease
under SFAS 98 "Accounting for Leases: Sale/Leaseback Transactions Involving Real
Estate; Sales-Type Leases of Real Estate; Definition of the Lease Term; an
Initial Direct Costs of Direct Financing Leases, an amendment of FASB Statements
No.13, 66, 91 and a rescission of FASB Statement No. 26 and Technical Bulletin
No. 79-11." The lease has an initial term of 36 years and the yearly operating
lease expense is approximately $17 million per year. Lease payments will
fluctuate from year to year, but are substantially paid over the first 16 years.
Asset Retirement Obligations: In 2003, KeySpan adopted SFAS 143, "Accounting for
Asset Retirement Obligations." SFAS 143 required us to record a liability and
corresponding asset representing the present value of legal obligations
associated with the retirement of tangible, long-lived assets that existed at
the inception of the obligation. At the time of implementation, KeySpan recorded
an asset retirement obligation related to its investment in Houston Exploration
and its other gas exploration and production subsidiaries. Since Houston
Exploration's operations have been deconsolidated, Houston Exploration's
liability is no longer reflected on KeySpan's Consolidated Balance Sheet. The
remaining asset retirement obligation is related to our investment in
Seneca-Upshur and was approximately $6.6 million at September 30, 2004.
KeySpan's largest asset base is its gas transmission and distribution system. A
legal obligation exists due to certain safety requirements at final abandonment.
In addition, a legal obligation may be construed to exist with respect to
KeySpan's liquefied natural gas ("LNG") storage tanks due to clean up
responsibilities upon cessation of use. However, mass assets such as storage,
transmission and distribution assets are believed to operate in perpetuity and,
therefore, have indeterminate cash flow estimates. Since that exposure is in
perpetuity and cannot be measured, no liability was recorded pursuant to SFAS
143. KeySpan's ARO will be re-evaluated in future periods until sufficient
information exists to determine a reasonable estimate of such obligation.
19
Environmental Matters
New York Sites: Within the State of New York we have identified 43 historical
manufactured gas plant ("MGP") sites and related facilities, which were owned or
operated by KeySpan subsidiaries or such companies' predecessors.
We have identified 28 of these sites as being associated with the historical
operations of KEDNY. One site has been fully remediated. The remaining 27 sites
will be investigated and, if necessary, remediated under the terms and
conditions of Administrative Orders on Consent ("ACO"), Voluntary Cleanup
Agreements ("VCA") or Brownfield Cleanup Agreements ("BCA"). Expenditures
incurred to date by us with respect to KEDNY MGP-related activities total $46.9
million.
We have identified 15 of these sites as being associated with the historical
operations of KEDLI. Expenditures incurred to date by us with respect to KEDLI
MGP-related activities total $39.4 million. One site has been fully investigated
and requires no further action. The remaining sites will be investigated and, if
necessary, remediated under the conditions of ACOs, VCAs or BCAs.
We presently estimate the remaining cost of our KEDNY and KEDLI MGP-related
environmental remediation activities will be $210.7 million, which amount has
been accrued by us as a reasonable estimate of probable cost for known sites.
Expenditures incurred to date by us with respect to these MGP-related activities
total $86.3 million.
With respect to remediation costs, the KEDNY and KEDLI rate plans generally
provide for the recovery from customers of investigation and remediation costs.
At September 30, 2004, we have reflected a regulatory asset of $232.4 million
for our KEDNY/KEDLI MGP sites. In accordance with NYPSC policy, KeySpan records
a reduction to regulatory liabilities as costs are incurred for environmental
clean-up activities. At September 30, 2004, these previously deferred regulatory
liabilities totaled $43.2 million. In October 2003, KEDNY and KEDLI filed a
joint petition with the NYPSC, which is still pending, seeking rate treatment
for additional environmental costs that may be incurred in the future.
We are also responsible for environmental obligations associated with the
Ravenswood facility, purchased from Consolidated Edison in 1999, including
remediation activities associated with its historical operations and those of
the MGP facilities that formerly operated at the site. We are not responsible
for liabilities arising from disposal of waste at off-site locations prior to
the acquisition closing and any monetary fines arising from Consolidated
Edison's pre-closing conduct. We presently estimate the remaining environmental
clean up activities for this site will be $3.1 million, which amount has been
accrued by us. Expenditures incurred to date total $1.9 million.
New England Sites: Within the Commonwealth of Massachusetts and the State of New
Hampshire, we are aware of 76 former MGP sites and related facilities within the
existing or former service territories of KEDNE.
20
Boston Gas Company, Colonial Gas Company and Essex Gas Company may have or share
responsibility under applicable environmental laws for the remediation of 66 of
these sites. A subsidiary of National Grid USA ("National Grid"), formerly New
England Electric System, has assumed responsibility for remediating 11 of these
sites, subject to a limited contribution from Boston Gas Company, and has
provided full indemnification to Boston Gas Company with respect to eight other
sites. In addition, Boston Gas Company, Colonial Gas Company, and Essex Gas
Company have each assumed responsibility for remediating three sites. At this
time, it is uncertain as to whether Boston Gas Company, Colonial Gas Company or
Essex Gas Company have or share responsibility for remediating any of the other
sites. No notice of responsibility has been issued to us for any of these sites
from any governmental environmental authority.
We presently estimate the remaining cost of these Massachusetts KEDNE
MGP-related environmental cleanup activities will be $21.1 million, which amount
has been accrued by us as a reasonable estimate of probable cost for known
sites. Expenditures incurred by KeySpan with respect to these MGP-related
activities total $16.5 million.
In September 2004, Boston Gas Company reached an agreement with an insurance
carrier for recovery of a portion of previously incurred environmental
expenditures. Under a previously issued MA DTE rate order, insurance and
third-party recoveries, after deducting legal fees, are shared between Boston
Gas and its firm gas customers. As a result of this agreement, in September 2004
Boston Gas Company recorded a $5 million benefit to operations and maintenance
expense.
We may have or share responsibility under applicable environmental laws for the
remediation of 10 MGP sites and related facilities associated with the
historical operations of EnergyNorth. At four of these sites we have entered
into cost sharing agreements with other parties who share responsibility for
remediation of these sites. EnergyNorth also has entered into an agreement with
the United States Environmental Protection Agency ("EPA") for the contamination
from the Nashua site that was allegedly commingled with asbestos at the Nashua
River Asbestos Site, adjacent to the Nashua MGP site.
We presently estimate the remaining cost of EnergyNorth MGP-related
environmental cleanup activities will be $12.5 million, which amount has been
accrued by us as a reasonable estimate of probable cost for known sites.
Expenditures incurred by KeySpan, with respect to these MGP-related activities
total $9.0 million.
By rate orders, the MA DTE and the New Hampshire Public Utility Commission
("NHPUC") provide for the recovery of site investigation and remediation costs
and, accordingly, at September 30, 2004, we have reflected a regulatory asset of
$49.6 million for the KEDNE MGP sites. Colonial Gas Company and Essex Gas
Company are not subject to the provisions of SFAS 71 and therefore have recorded
no regulatory asset. However, rate plans currently in effect for these
subsidiaries provide for the recovery of investigation and remediation costs.
21
KeySpan New England, LLC Sites: We are aware of three non-utility sites
associated with KeySpan New England, LLC for which we may have or share
environmental remediation or ongoing maintenance responsibility. These three
sites, located in Philadelphia, Pennsylvania, New Haven, Connecticut and
Everett, Massachusetts, were associated with historical operations involving the
production of coke and related industrial processes. Honeywell International,
Inc. and Beazer East, Inc. (both former owners and/or operators of certain
facilities at Everett (the "Everett Facility") together with KeySpan, have
entered into an ACO with the Massachusetts Department of Environmental
Protection for the investigation and development of a remedial response plan for
a portion of that site. KeySpan, Honeywell and Beazer East have entered into a
cost-sharing agreement under which each company has agreed to pay one-third of
the costs of compliance with the consent order, while preserving any claims it
may have against the other companies for, among other things, reallocation of
proportionate liability.
We presently estimate the remaining cost of our environmental cleanup activities
for the three non-utility sites will be approximately $22.0 million, which
amount has been accrued by us as a reasonable estimate of probable costs for
known sites. Expenditures incurred by KeySpan with respect to these sites total
$10.8 million.
We believe that in the aggregate, the accrued liability for these MGP sites and
related facilities identified above are reasonable estimates of the probable
cost for the investigation and remediation of these sites and facilities. As
circumstances warrant, we periodically re-evaluate the accrued liabilities
associated with MGP sites and related facilities. We may be required to
investigate and, if necessary, remediate each site previously noted, or other
currently unknown former sites and related facility sites, the cost of which is
not presently determinable but may be material to our financial position,
results of operations or cash flows. Remediation costs for each site may be
materially higher than noted, depending upon remediation experience, selected
end use for each site, and actual environmental conditions encountered.
See KeySpan's Annual Report on Form 10-K for the year ended December 31, 2003
Note 7 to those Consolidated Financial Statements "Contractual Obligations,
Financial Guarantees and Contingencies" for further information on environmental
matters.
Legal Matters
From time to time we are subject to various legal proceedings arising out of the
ordinary course of our business. Except as described below, or in KeySpan's
Annual Report on Form 10-K for the year ended December 31, 2003, we do not
consider any of such proceedings to be material to our business or likely to
result in a material adverse effect on our results of operations, financial
condition or cash flows.
22
As previously reported, KeySpan and certain of its current and former officers
and directors are defendants in a consolidated class action lawsuit filed in the
United States District Court for the Eastern District of New York. This lawsuit
alleges, among other things, violations of Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934, as amended ("Exchange Act"), in connection with
disclosures relating to or following the acquisition of the Roy Kay companies.
In June 2004, the parties reached an agreement in principle to settle the
consolidated class action lawsuit. The proposed settlement provides for KeySpan
to make certain payments to plaintiffs, all of which is to be funded by the
insurance carrier providing liability coverage for KeySpan's directors and
officers. While KeySpan continues to deny any wrongdoing, we believe the
proposed settlement is in the best interest of KeySpan and its shareholders. The
settlement is subject to court approval and finalization of all necessary
documentation, the timing of which cannot be determined.
KeySpan subsidiaries, along with several other parties, have been named as
defendants in numerous proceedings filed by plaintiffs claiming various degrees
of injury from asbestos exposure at generating facilities formerly owned by Long
Island Lighting Company ("LILCO") and others. In connection with the May 1998
transaction with LIPA, costs incurred by KeySpan for liabilities for asbestos
exposure arising from the activities of the generating facilities previously
owned by LILCO are recoverable from LIPA through the Power Supply Agreement
("PSA") between LIPA and KeySpan.
KeySpan is unable to determine the outcome of the outstanding asbestos
proceedings, but does not believe that such outcome, if adverse, will have a
material effect on its financial condition, results of operation or cash flows.
KeySpan believes that its cost recovery rights under the PSA, its
indemnification rights against third parties and its insurance coverage (above
applicable deductible limits) cover its exposure for asbestos liabilities
generally.
23
Financial Guarantees
KeySpan has issued financial guarantees in the normal course of business, on
behalf of its subsidiaries, to various third-party creditors. At September 30,
2004, the following amounts would have to be paid by KeySpan in the event of
non-payment by the primary obligor at the time payment is due:
- -----------------------------------------------------------------------------------------------------------------
Amount of
Nature of Guarantee (In Thousands of Dollars) Exposure Expiration Dates
- -----------------------------------------------------------------------------------------------------------------
Medium-Term Notes - KEDLI (i) $ 525,000 2008-2010
Industrial Development Revenue Bonds (ii) 128,000 2027
Ravenswood - Master Lease (iii) 425,000 2019
Ravenswood - Sale/leaseback (iv) 385,000 2040
Surety Bonds (v) 269,000 Revolving
Commodity Guarantees and Other (vi) 77,000 2005
Letters of Credit (vii) 74,000 2005
- -----------------------------------------------------------------------------------------------------------------
$ 1,883,000
- -----------------------------------------------------------------------------------------------------------------
The following is a description of KeySpan's outstanding subsidiary guarantees:
(i) KeySpan has fully and unconditionally guaranteed $525 million to holders of
Medium-Term Notes issued by KEDLI. These notes are due to be repaid on
January 15, 2008 and February 1, 2010. KEDLI is required to comply with
certain financial covenants under the debt agreements. The face value of
these notes is included in long-term debt on the Consolidated Balance
Sheet.
(ii) KeySpan has fully and unconditionally guaranteed the payment obligations of
its subsidiaries with regard to $128 million of Industrial Development
Revenue Bonds issued through the Nassau County and Suffolk County
Industrial Development Authorities for the construction of two
electric-generation peaking plants on Long Island. The face value of these
notes are included in long-term debt on the Consolidated Balance Sheet.
(iii)KeySpan has guaranteed all payment and performance obligations of KeySpan
Ravenswood, LLC, the lessee under the Master Lease. The initial term of the
Master Lease expired on June 20, 2004 and was extended until June 20, 2009.
The Master Lease is classified as $412.3 million long-term debt on the
Consolidated Balance Sheet.
(iv) KeySpan has guaranteed all payment and performance obligations of KeySpan
Ravenswood, LLC, the lessee under the sale/leaseback transaction associated
with the 250 MW Ravenswood Expansion. The initial term of the lease is for
36 years. As noted previously, this lease qualifies as an operating lease
and is therefore not reflected on the Consolidated Balance Sheet.
24
(v) KeySpan has agreed to indemnify the issuers of various surety and
performance bonds associated with certain construction projects currently
being performed by subsidiaries within the Energy Services segment. In the
event that the operating companies in the Energy Services segment fail to
perform their obligations under contract, the injured party may demand that
the surety make payments or provide services under the bond. KeySpan would
then be obligated to reimburse the surety for any expenses or cash outlays
it incurs.
(vi) KeySpan has guaranteed commodity-related payments for certain of its
subsidiaries. These guarantees are provided to third-parties to facilitate
physical and financial transactions involved in the purchase of natural
gas, oil and other petroleum products for electric production and marketing
activities. The guarantees cover actual purchases by these subsidiaries
that are still outstanding as of September 30, 2004.
(vii)KeySpan has arranged for stand-by letters of credit to be issued to third
parties that have extended credit to certain subsidiaries. Certain vendors
require us to post letters of credit to guarantee subsidiary performance
under our contracts and to ensure payment to our subsidiary subcontractors
and vendors under those contracts. Certain of our vendors also require
letters of credit to ensure reimbursement for amounts they are disbursing
on behalf of our subsidiaries, such as to beneficiaries under our
self-funded insurance programs. Such letters of credit are generally issued
by a bank or similar financial institution. The letters of credit commit
the issuer to pay specified amounts to the holder of the letter of credit
if the holder demonstrates that we have failed to perform specified
actions. If this were to occur, KeySpan would be required to reimburse the
issuer of the letter of credit.
To date, KeySpan has not had a claim made against it for any of the above
guarantees and we have no reason to believe that our subsidiaries will
default on their current obligations. However, we cannot predict when or if
any defaults may take place or the impact any such defaults may have on our
consolidated results of operations, financial condition or cash flows.
Other Contingencies: We derive a substantial portion of our revenues in our
Electric Services segment from a series of agreements with LIPA pursuant to
which we manage LIPA's transmission and distribution system and supply the
majority of LIPA's customers' electricity needs. The agreements terminate at
various dates between May 29, 2006 and May 28, 2013, and at this time we can
provide no assurance that any of the agreements will be renewed or extended, or
if they were to be renewed or extended, the terms and conditions thereof. In
addition, given the complexity of these agreements, disputes arise from time to
time between KeySpan and LIPA concerning the rights and obligations of each
party to make and receive payments as required pursuant to the terms of these
agreements. As a result, KeySpan is unable to determine what effect, if any, the
ultimate resolution of these disputes will have on its financial condition,
results of operations or cash flows.
25
In addition, LIPA is in the process of performing a long-term strategic review
initiative regarding its future direction. It has engaged a team of advisors and
consultants and is conducting public hearings to develop recommendations to be
submitted to the LIPA Trustees by year-end. Some of the strategic options that
LIPA is considering include whether LIPA should continue its operations as they
presently exist, fully municipalize or privatize, sell some, but not all of
their assets and become a regulator of rates and services, or merge with one or
more utilities. In the near term, LIPA must make a determination by May 2005 as
to whether they will exercise its option to purchase our Long Island generating
plants pursuant to the terms of the Generation Purchase Rights Agreement. Until
LIPA makes a determination on its future direction, we are unable to determine
what the outcome of this strategic review will have on our financial condition,
results of operations or cash flows. Any action that may be taken will have to
take into consideration the long-term nature of our existing contracts.
7. STOCK OPTIONS
Stock options have been issued to KeySpan officers, directors and certain other
management employees and consultants as approved by the Board of Directors.
These options generally vest over a three-to-five year period and have a
ten-year exercise period. Moreover, under a separate plan, Houston Exploration
has issued stock options to its directors and key Houston Exploration employees.
(Beginning in 2004, KeySpan officers that serve on the Houston Exploration Board
of Directors do not receive Houston Exploration stock options.) In 2003, KeySpan
and Houston Exploration adopted the prospective method of transition of
accounting for stock option expense in accordance with SFAS 148 "Accounting for
Stock-Based Compensation - Transition and Disclosure." Accordingly, compensation
expense has been recognized by employing the fair value recognition provisions
of SFAS 123 "Accounting for Stock-Based Compensation" for grants awarded after
January 1, 2003.
KeySpan and Houston Exploration continue to apply APB Opinion 25, "Accounting
for Stock Issued to Employees," and related Interpretations in accounting for
grants awarded prior to January 1, 2003. Accordingly, no compensation cost has
been recognized for these fixed stock option plans in the Consolidated Financial
Statements since the exercise prices and market values were equal on the grant
dates. Had compensation cost for these plans been determined based on the fair
value at the grant dates for awards under the plans consistent with SFAS 123,
net income and earnings per share would have decreased to the pro-forma amounts
indicated below. The 2004 pro-forma impact of Houston Exploration's stock
options are reflected for the five month period ended May 31, 2004.
26
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Thousands of Dollars, Except Per Share Amounts) 2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------------------------
Earnings available for common stock: $ (117,139) $ 11,124 $ 258,375 $ 245,529
As reported
Add: recorded stock-based compensation expense, net of tax 1,363 868 4,156 3,132
Deduct: total stock-based compensation expense, net of tax (1,935) (2,707) (6,894) (9,043)
- -----------------------------------------------------------------------------------------------------------------------------------
Pro-forma earnings $ (117,711) $ 9,285 $ 255,637 $ 239,618
- -----------------------------------------------------------------------------------------------------------------------------------
Earnings per share:
Basic - as reported $ (0.73) $ 0.07 $ 1.61 $ 1.56
Basic - pro-forma $ (0.73) $ 0.06 $ 1.60 $ 1.52
Diluted - as reported $ (0.73) $ 0.07 $ 1.60 $ 1.55
Diluted - pro-forma $ (0.73) $ 0.06 $ 1.59 $ 1.51
- -----------------------------------------------------------------------------------------------------------------------------------
8. POSTRETIREMENT BENEFITS
Pension Plans: The following information represents the consolidated net
periodic pension cost for the nine months ended September 30, 2004 and 2003 for
our noncontributory defined benefit pension plans which cover substantially all
employees. Benefits are based on years of service and compensation. Funding for
pensions is in accordance with requirements of federal law and regulations.
KEDLI and Boston Gas Company are subject to certain deferral accounting
requirements mandated by the NYPSC and MA DTE, respectively for pension costs
and other postretirement benefit costs. Further, KeySpan's electric subsidiaries
are subject to certain "true-up" provisions in accordance with the LIPA service
agreements.
The calculation of net periodic pension cost is as follows:
- ----------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003
- ----------------------------------------------------------------------------------------------------------------------
Service cost, benefits earned during the period $ 39,681 $ 35,648
Interest cost on projected benefit obligation 108,181 103,703
Expected return on plan assets (118,700) (97,917)
Net amortization and deferral 47,480 50,212
- ----------------------------------------------------------------------------------------------------------------------
Total pension cost $ 76,642 $ 91,646
- ----------------------------------------------------------------------------------------------------------------------
Other Postretirement Benefits: The following information represents the
consolidated net periodic other postretirement benefit cost for the nine months
ended September 30, 2004 and 2003 for our noncontributory defined benefit plans
covering certain health care and life insurance benefits for retired employees.
We have been funding a portion of future benefits over employees' active service
lives through Voluntary Employee Beneficiary Association ("VEBA") trusts.
Contributions to VEBA trusts are tax deductible, subject to limitations
contained in the Internal Revenue Code.
27
Net periodic other postretirement benefit cost included the following
components:
- ----------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003
- ----------------------------------------------------------------------------------------------------------------
Service cost, benefits earned during the period $ 15,090 $ 14,119
Interest cost on accumulated
postretirement benefit obligation 55,508 52,352
Expected return on plan assets (25,419) (20,648)
Net amortization and deferral 35,097 26,861
- ----------------------------------------------------------------------------------------------------------------
Other postretirement cost $ 80,276 $ 72,685
- ----------------------------------------------------------------------------------------------------------------
In 2004, KeySpan is expected to contribute approximately $102 million to its
pension plans and approximately $40 million to its other postretirement benefit
plans. For the nine months ended September 30, 2004, $130 million has been
contributed. These estimated contribution levels are subject to change based on
future market returns, interest rates and certain other measurements. Actual
contributions, therefore, may vary from these levels.
9. LONG-TERM DEBT and COMMERCIAL PAPER
In August 2004, KeySpan redeemed approximately $758 million of outstanding debt.
The table below indicates the various series of debt redeemed and the associated
KeySpan subsidiary:
- ----------------------------------------------------------------------------------------------------------------------------------
KeySpan Subsidiary Series Due Date Amount ($000)
- ----------------------------------------------------------------------------------------------------------------------------------
KeySpan Corporation 7.25% Medium Term Notes November 2005 $ 700,000
EnergyNorth Natural Gas 9.70% Series B September 2019 7,000
EnergyNorth Natural Gas 9.75% Series C September 2020 10,000
EnergyNorth Natural Gas 8.44% Series D January 2009 1,667
EnergyNorth Natural Gas 7.40% Series E September 2027 21,285
Essex Gas Company 10.10% Series 1990 December 2020 8,000
Essex Gas Company 7.28% Series 1996 December 2016 10,000
- ----------------------------------------------------------------------------------------------------------------------------------
$ 757,952
- ----------------------------------------------------------------------------------------------------------------------------------
KeySpan incurred $54.5 million in call premiums associated with these
redemptions, of which $45.9 was expensed and recorded in other income and
deductions on the Consolidated Statement of Income. The remaining amount of the
call premiums have been deferred for future recovery. Further, KeySpan wrote-off
$8.2 million of previously deferred financing costs which have been reflected in
interest expense on the Consolidated Statement of Income. The total after-tax
expense of the debt redemption was $29.3 million or $0.18 per share.
28
Also during the third quarter of 2004, KEDNY retired a portion, $8.0 million, of
its outstanding Gas Facilities Revenue Bonds. The funds used to retire this debt
were drawn from a special deposit defeasance trust previously established by
KEDNY. Approximately $640 million of Gas Facilities Revenue Bonds remain
outstanding.
At September 30, 2004, KeySpan had $460 million of MEDS Equity Units outstanding
at 8.75% consisting of a three-year forward purchase contract for our common
stock and a six-year note. The purchase contract commits us, in May 2005, three
years after the date of issuance of the MEDS Equity Units, to issue and the
investors to purchase, a number of shares of our common stock based on a formula
tied to the market price of our common stock at that time. The 8.75% coupon is
composed of interest payments on the six-year note of 4.9% and premium payments
on the three-year equity forward contract of 3.85%. These instruments have been
recorded as long-term debt on the Consolidated Balance Sheet. Further, upon
issuance of the MEDS Equity Units, we recorded a direct charge to retained
earnings of $49.1 million, which represents the present value of the forward
contract's premium payments.
There were 9.2 million MEDS Equity units issued which are subject to conversion
upon execution of the three-year forward purchase contract. The number of shares
to be issued depends on the average closing price of KeySpan's common stock over
the 20 day trading period ending on the third trading day prior to May 16, 2005.
If the average closing price over this time frame is less than or equal to
$35.30 of KeySpan's common stock, 13 million shares will be issued. If the
average closing price over this time frame is greater than or equal to $42.36,
10.9 million shares will be issued. The number of shares issued at a price
between $35.30 and $42.36 will be between 10.9 million and 13 million shares
based upon a sliding scale.
These securities are currently not considered convertible instruments for
purposes of applying SFAS 128 "Earnings Per Share" calculations, unless or until
such time as the market value of KeySpan's common stock reaches a threshold
appreciation price ($42.36 per share) that is higher than the current per share
market value. Interest payments do, however, reduce net income and earnings per
share.
In June 2004, KeySpan completed the restructuring of its credit facilities. We
entered into a new $640 million five year revolving credit facility to replace
the $450 million, 364 day facility which expired in June. We also amended our
existing three year $850 million facility due June 2006 to reduce commitments
thereunder by $190 million to a new level of $660 million. The two credit
facilities total $1.3 billion and are each syndicated among sixteen banks. These
facilities continue to support KeySpan's commercial paper program for working
capital needs.
The fees for these facilities are subject to a ratings-based grid, with an
annual fee of 0.08% on the new five-year facility and 0.125% on the existing
three-year facility. Both credit agreements allow for KeySpan to borrow using
several different types of loans; specifically, Eurodollar loans, Adjustable
Bank Rate (ABR) loans, or competitively bid loans. Eurodollar loans in the
five-year facility are based on the Eurodollar rate plus a margin of 0.40% for
loans up to 33% of the total five-year facility, and an additional 0.125% for
29
loans over 33% of the total five-year facility. In the three-year facility
Eurodollar loans are based on the Eurodollar rate plus a margin of 0.625% for
loans up to 33% of the total three-year facility, and an additional 0.125% for
loans over 33% of the total three-year facility. ABR loans are based on the
highest of the Prime Rate, the base CD rate plus 1%, or the Federal Funds
Effective Rate plus 0.5%. Competitive bid loans are based on bid results
requested by KeySpan from the lenders. We do not anticipate borrowing against
these facilities; however, if the credit rating on our commercial paper program
were to be downgraded, it may be necessary to do so.
The facilities contain certain affirmative and negative operating covenants,
including restrictions on KeySpan's ability to mortgage, pledge, encumber or
otherwise subject its property to any lien, as well as certain financial
covenants that require us to, among other things, maintain a consolidated
indebtedness to consolidated capitalization ratio of no more than 64% until the
expiration of the existing three-year facility in 2006, at which time it will be
lowered to 62%. Violation of this covenant could result in the termination of
the facilities and the required repayment of amounts borrowed thereunder, as
well as possible cross defaults under other debt agreements.
10. GAS EXPLORATION and PRODUCTION PROPERTY - DEPLETION
As described in Note 2 "Business Segments," KeySpan's investments in gas
exploration and production activities consists of its approximate 23.5%
ownership interest in Houston Exploration, as well as KeySpan's wholly-owned
subsidiary KeySpan Exploration and Production, which is engaged in a joint
drilling program with Houston Exploration. Further, KeySpan's investments in
these activities also includes its wholly-owned subsidiary Seneca-Upshur. These
assets are accounted for under the full cost method of accounting. Under the
full cost method, costs of acquisition, exploration and development of natural
gas and oil reserves plus asset retirement obligations are capitalized into a
"full cost pool" as incurred. Unproved properties and related costs are excluded
from the depletion and amortization base until a determination as to the
existence of proved reserves. Properties are depleted and charged to operations
using the unit of production method.
To the extent that such capitalized costs (net of accumulated depletion) less
deferred taxes exceed the present value (using a 10% discount rate) of estimated
future net cash flows from proved natural gas and oil reserves and the lower of
cost or fair value of unproved properties, less deferred taxes, such excess
costs are charged to operations, but would not have an impact on cash flows.
Once incurred, such impairment of gas properties is not reversible at a later
date even if gas prices increase. The ceiling test is calculated using natural
gas and oil prices in effect as of the balance sheet date, adjusted for
outstanding derivative instruments, held flat over the life of the reserves.
As a result of the stock transaction previously mentioned, KeySpan now accounts
for its investment in Houston Exploration on the equity method, i.e. Houston
Exploration's operations are not consolidated with KeySpan's other subsidiaries.
Therefore, we are now required to calculate the ceiling test on KeySpan
Exploration and Production's and Seneca-Uphsur's assets independently of Houston
Exploration's assets. Based on a report furnished by an independent reservoir
30
engineer during the second quarter of 2004, it was determined that the remaining
proved undeveloped oil reserves held in the joint venture required a substantial
investment in order to develop. Therefore, KeySpan and Houston Exploration
elected not to develop these oil reserves. As a result, in the second quarter of
2004, we recorded a $48.2 million non-cash impairment charge to write down our
wholly-owned gas exploration and production subsidiaries' assets. This charge
was recorded in depreciation, depletion and amortization on the Consolidated
Statement of Income.
11. PREFERRED STOCK
In July 2004, KeySpan redeemed 83,268 shares of preferred stock 6.00% Series A
par value $100 that were previously issued in a private placement. KeySpan
redeemed these shares at a 2% premium and incurred a cash expenditure of $8.5
million.
12. GOODWILL IMPAIRMENT
In connection with the preparation of third quarter financial statements,
KeySpan conducted an evaluation of the carrying value of goodwill recorded in
its Energy Services segment. As noted in prior SEC filings, KeySpan records
goodwill on purchased transactions, representing the excess of acquisition cost
over the fair value of net assets acquired. As prescribed in SFAS 142 "Goodwill
and Other Intangible Assets", KeySpan is required to compare the fair value of a
reporting unit to its carrying amount, including goodwill. This evaluation is
required to be performed at least annually, unless facts and circumstances
indicate that the evaluation should be performed at an interim period during the
year. Prior to this evaluation, the recorded goodwill for the Energy Services
segment, as a result of prior acquisitions, was approximately $173 million.
As a result of an extremely competitive market and sluggish economic conditions
within the construction industry in the Northeastern United States, the Energy
Services segment has experienced significantly lower operating profits and cash
flows than originally projected. As previously reported, management has been
reviewing the operating performance of this segment. At a meeting held on
November 2, 2004, KeySpan's Board of Directors authorized management to begin
the process of disposing of a significant portion of its ownership interests in
certain companies within the Energy Services segment - specifically those
companies engaged in mechanical contracting activities. For the nine months
ended September 30, 2004, the mechanical contracting activities contributed
approximately 60% of the revenues recorded in the Energy Services segment.
Based upon the results through September 30, 2004 experienced by the Energy
Services segment and management's opinion that it was likely that a significant
portion of the Energy Services segment will be sold in the coming months,
management concluded that KeySpan was required under paragraph 28 of SFAS 142,
to evaluate the goodwill recorded for the entire Energy Services segment in
connection with the preparation and review of its financial statements for the
quarter.
31
As a result of this interim evaluation, KeySpan recorded a non-cash goodwill
impairment charge of $122.2 million ($90.4 million after tax, or $0.56 per
share) in the third quarter of 2004. KeySpan employed a combination of two
methodologies in determining the estimated fair value for its investment in the
Energy Services segment, a market valuation approach and an income valuation
approach. Under the market valuation approach, KeySpan utilized a range of
near-term potential realizable values for the mechanical contracting businesses.
Under the income valuation approach, the fair value was obtained by discounting
the sum of (i) the expected future cash flows and (ii) the terminal value.
KeySpan utilized certain significant assumptions in this valuation, specifically
the weighted-average cost of capital, short and long-term growth rates and
expected future cash flows. Therefore, the significant assumptions used in this
interim evaluation may change in future evaluations. Approximately $50 million
of goodwill remains in this segment.
In addition, we will continue to evaluate the fair value of the mechanical
contracting companies in relation to potential disposition alternatives. As a
result of this evaluation we may also be required to write-down the carrying
value of the mechanical contracting companies in the near term in an amount that
can not currently be determined.
At this point in time, we are unable to predict if any additional impairment
charges may be required for this segment, the timing of any such charges, the
impact any such charges would have on our financial position and results of
operations or the timing of any sales of our ownership interest in certain
companies operating in this segment.
32
13. KEYSPAN GAS EAST CORPORATION SUMMARY FINANCIAL INFORMATION
KEDLI is a wholly-owned subsidiary of KeySpan. KEDLI was formed on May 7, 1998
and on May 28, 1998 acquired substantially all of the assets related to the gas
distribution business of LILCO. KEDLI established a program for the issuance,
from time to time, of up to $600 million aggregate principal amount of
Medium-Term Notes, which are fully and unconditionally guaranteed by the parent,
KeySpan Corporation. On February 1, 2000, KEDLI issued $400 million of 7.875%
Medium-Term Notes due 2010. In January 2001, KEDLI issued an additional $125
million of Medium-Term Notes at 6.9% due January 2008. The following condensed
financial statements are required to be disclosed by SEC regulations and set
forth those of KEDLI, KeySpan Corporation as guarantor of the Medium-Term Notes
and our other subsidiaries on a combined basis.
- ------------------------------------------------------------------------------------------------------------------------------------
Statement of Income
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, 2004
Other
(In Thousands of Dollars) Guarantor KEDLI Subsidiaries Eliminations Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Revenues $ 152 $ 114,252 936,182 $ (152) $1,050,434
------------------------------------------------------------------------------------------
Operating Expenses
Purchased gas - 49,994 136,625 - 186,619
Fuel and purchased power - - 176,028 - 176,028
Operations and maintenance 2,102 29,893 402,879 - 434,874
Intercompany expense - 1,341 (1,341) - -
Depreciation and amortization - 13,799 79,621 - 93,420
Goodwill impairment charge - - 122,229 - 122,229
Operating taxes - 15,538 73,987 89,525
------------------------------------------------------------------------------------------
Total Operating Expenses 2,102 110,565 990,028 - 1,102,695
------------------------------------------------------------------------------------------
Income from equity investments - - 16,213 - 16,213
------------------------------------------------------------------------------------------
Operating Income (Loss) (1,950) 3,687 (37,633) (152) (36,048)
------------------------------------------------------------------------------------------
Interest charges (54,203) (16,306) (67,495) 49,696 (88,308)
Other income and (deductions) (88,066) 192 9,326 36,815 (41,733)
------------------------------------------------------------------------------------------
Total Other Income and (Deductions) (142,269) (16,114) (58,169) 86,511 (130,041)
------------------------------------------------------------------------------------------
Income Taxes (Benefit) (30,432) (2,626) (17,252) - (50,310)
------------------------------------------------------------------------------------------
Net Income $ (113,787) $ (9,801) $ (78,550) $ 86,359 $ (115,779)
==========================================================================================
33
- -----------------------------------------------------------------------------------------------------------------------------------
Statement of Income
- -----------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, 2003
Other
(In Thousands of Dollars) Guarantor KEDLI Subsidiaries Eliminations Consolidated
- ---------------------------------------------------------------------------------------------------------------------------------
Revenues $ 185 $ 99,170 $ 1,032,644 $ (185) $ 1,131,814
------------------------------------------------------------------------------------------
Operating Expenses
Purchased gas 37,038 136,078 172,452
Fuel and purchased power 132,649 133,313
Operations and maintenance 6,742 33,457 467,182 507,381
Intercompany expense 5,142 310 (310) (5,142)
Depreciation and amortization (13) 13,519 122,150 135,656
Operating taxes 1,824 16,557 73,409 91,790
------------------------------------------------------------------------------------------
Total Operating Expenses 13,695 100,881 931,158 (5,142) 1,040,592
------------------------------------------------------------------------------------------
Gain on sale of property - 13,974 - - 13,974
Income from Equity Investments - - 2,727 - 2,727
------------------------------------------------------------------------------------------
Operating Income (Loss) (13,510) 12,263 104,213 4,957 107,923
------------------------------------------------------------------------------------------
Interest charges (54,233) (15,661) (54,205) 45,733 (78,366)
Other income and (deductions) 67,923 2,838 (11,939) (68,391) (9,569)
------------------------------------------------------------------------------------------
Total Other Income and (Deductions) 13,690 (12,823) (66,144) (22,658) (87,935)
------------------------------------------------------------------------------------------
Income Taxes (Benefit) (12,574) 1,223 18,754 - 7,403
------------------------------------------------------------------------------------------
Net Income (Loss) $12,754 $ (1,783) $ 19,315 $ (17,701) $ 12,585
==========================================================================================
- -----------------------------------------------------------------------------------------------------------------------------------
Statement of Income
- -----------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30, 2004
Other
(In Thousands of Dollars) Guarantor KEDLI Subsidiaries Eliminations Consolidated
- ---------------------------------------------------------------------------------------------------------------------------------
Revenues $ 465 $ 766,709 $ 4,245,069 $ (465) $ 5,011,778
------------------------------------------------------------------------------------------
Operating Expenses
Purchased gas - 437,990 1,338,332 - 1,776,322
Fuel and purchased power - - 407,987 - 407,987
Operations and maintenance (2,959) 96,833 1,310,961 - 1,404,835
Intercompany expense - 4,129 (4,129) - -
Depreciation and amortization - 62,048 392,689 - 454,737
Goodwill impairment charge - 122,229 - 122,229
Operating taxes - 47,814 254,329 - 302,143
------------------------------------------------------------------------------------------
Total Operating Expenses (2,959) 648,814 3,822,398 - 4,468,253
------------------------------------------------------------------------------------------
Income from Equity Investments - - 30,342 - 30,342
------------------------------------------------------------------------------------------
Operating Income (Loss) 3,424 117,895 453,013 (465) 573,867
------------------------------------------------------------------------------------------
Interest charges (160,968) (47,000) (208,458) 155,578 (260,848)
Other income and (deductions) 386,109 724 187,397 (457,809) 116,421
------------------------------------------------------------------------------------------
Total Other Income and (Deductions) 225,141 (46,276) (21,061) (302,231) (144,427)
------------------------------------------------------------------------------------------
Income Taxes (Benefit) (40,067) 22,428 184,424 - 166,785
------------------------------------------------------------------------------------------
Net Income (Loss) $268,632 $ 49,191 $ 247,528 $ (302,696) $ 262,655
==========================================================================================
34
- ------------------------------------------------------------------------------------------------------------------------------------
Statement of Income
- ------------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30, 2003
Other
(In Thousands of Dollars) Guarantor KEDLI Subsidiaries Eliminations Consolidated
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues $ 362 $ 754,855 $ 4,297,636 $ (362) $ 5,052,491
-------------------------------------------------------------------------------------
Operating Expenses
Purchased gas - 414,658 1,378,259 - 1,792,917
Fuel and purchased power - - 333,311 - 333,311
Operations and maintenance 8,577 104,437 1,402,192 - 1,515,206
Intercompany expense 5,207 2,227 (2,227) (5,207) -
Depreciation and amortization (53) 58,503 364,467 - 422,917
Operating taxes - 57,516 254,238 - 311,754
-------------------------------------------------------------------------------------
Total Operating Expenses 13,731 637,341 3,730,240 (5,207) 4,376,105
-------------------------------------------------------------------------------------
Gain on sale of property - 13,974 - - 13,974
Income from Equity Investments 108 - 12,378 - 12,486
-------------------------------------------------------------------------------------
Operating Income (Loss) (13,261) 131,488 579,774 4,845 702,846
-------------------------------------------------------------------------------------
Interest charges (154,113) (46,771) (163,224) 137,605 (226,503)
Other income and (deductions) 395,934 (6,188) (53,383) (397,254) (60,891)
-------------------------------------------------------------------------------------
Total Other Income and (Deductions) 241,821 (52,959) (216,607) (259,649) (287,394)
-------------------------------------------------------------------------------------
Income Taxes (Benefit) (21,521) 30,756 156,479 - 165,714
-------------------------------------------------------------------------------------
Earnings before Change in Accounting
Principle 250,081 47,773 206,688 (254,804) 249,738
Cummulative Effect of Change in Accounting
Principle - - 174 - 174
-------------------------------------------------------------------------------------
Net Income (Loss) $ 250,081 $ 47,773 $ 206,862 $ (254,804) $ 249,912
=====================================================================================
35
- ------------------------------------------------------------------------------------------------------------------------------------
Balance Sheet
- ------------------------------------------------------------------------------------------------------------------------------------
September 30, 2004
Other
Guarantor KEDLI Subsidiaries Eliminations Consolidated
------------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash and temporary cash investments $ 74,262 $ 2,032 $ 285,003 $ - $ 361,297
Accounts receivable, net 8,320 100,856 617,435 - 726,611
Other current assets 3,742 165,305 824,107 - 993,154
------------------------------------------------------------------------------------------
86,324 268,193 1,726,545 - 2,081,062
------------------------------------------------------------------------------------------
Investments 4,686,201 2,035 420,740 (4,592,372) 516,604
------------------------------------------------------------------------------------------
Property
Gas 1,968,793 4,821,354 - 6,790,147
Other - 2,972,106 - 2,972,106
Accumulated depreciation and depletion (328,711) (2,484,381) - (2,813,092)
------------------------------------------------------------------------------------------
- 1,640,082 5,309,079 - 6,949,161
------------------------------------------------------------------------------------------
Intercompany Accounts Receivable 2,198,997 890 1,808,897 (4,008,784) -
Deferred Charges 374,159 236,171 2,384,416 - 2,994,746
------------------------------------------------------------------------------------------
Total Assets $ 7,345,681 $ 2,147,371 $ 11,649,677 $ (8,601,156) $ 12,541,573
==========================================================================================
LIABILITIES AND CAPITALIZATION
Current Liabilities
Accounts payable $ 52,148 $ 56,881 $ 553,098 $ - $ 662,127
Commercial paper 575,375 - - - 575,375
Other current liabilities 61,477 58,035 133,410 - 252,922
------------------------------------------------------------------------------------------
689,000 114,916 686,508 - 1,490,424
------------------------------------------------------------------------------------------
Intercompany Accounts Payable - - 2,683,434 (2,683,434) -
------------------------------------------------------------------------------------------
Deferred Credits and Other Liabilities
Deferred income tax (88,559) 366,055 813,947 - 1,091,443
Other deferred credits and liabilities 523,733 184,082 997,210 - 1,705,025
------------------------------------------------------------------------------------------
435,174 550,137 1,811,157 - 2,796,468
------------------------------------------------------------------------------------------
Capitalization
Common shareholders' equity 3,789,308 831,414 3,711,882 (4,592,372) 3,740,232
Preferred stock 75,000 - - 75,000
Long-term debt 2,357,199 650,904 2,741,109 (1,325,350) 4,423,862
------------------------------------------------------------------------------------------
Total Capitalization 6,221,507 1,482,318 6,452,991 (5,917,722) 8,239,094
------------------------------------------------------------------------------------------
Minority Interest in Subsidiary Companies - - 15,587 - 15,587
------------------------------------------------------------------------------------------
Total Liabilities & Capitalization $ 7,345,681 $ 2,147,371 $ 11,649,677 $ (8,601,156) $ 12,541,573
==========================================================================================
36
- ------------------------------------------------------------------------------------------------------------------------------------
Balance Sheet
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 2003
Other
Guarantor KEDLI Subsidiaries Eliminations Consolidated
-----------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash and temporary cash investments $ 97,567 $ 1,554 $ 106,630 $ - $ 205,751
Accounts receivable, net 3,298 209,151 1,243,459 - 1,455,908
Other current assets 3,250 130,994 590,996 - 725,240
-----------------------------------------------------------------------------------------
104,115 341,699 1,941,085 - 2,386,899
-----------------------------------------------------------------------------------------
Investments and Other 4,475,949 1,123 153,520 (4,382,027) 248,565
-----------------------------------------------------------------------------------------
Property
Gas - 1,899,375 4,622,876 - 6,522,251
Other - - 6,150,355 - 6,150,355
Accumulated depreciation and depletion - (312,204) (3,466,099) - (3,778,303)
-----------------------------------------------------------------------------------------
- 1,587,171 7,307,132 - 8,894,303
-----------------------------------------------------------------------------------------
Intercompany Accounts Receivable 3,105,571 - 1,274,293 (4,379,864) -
Deferred Charges 374,076 237,870 2,498,469 - 3,110,415
-----------------------------------------------------------------------------------------
Total Assets $ 8,059,711 $ 2,167,863 $ 13,174,499 $ (8,761,891) $ 14,640,182
=========================================================================================
LIABILITIES AND CAPITALIZATION
Current Liabilities
Accounts payable $ 125,892 $ 165,613 $ 850,092 $ - $ 1,141,597
Commercial paper 481,900 - - - 481,900
Other current liabilities 129,168 16,125 80,026 - 225,319
-----------------------------------------------------------------------------------------
736,960 181,738 930,118 - 1,848,816
-----------------------------------------------------------------------------------------
Intercompany Accounts Payable - 116,197 2,679,101 (2,795,298) -
-----------------------------------------------------------------------------------------
Deferred Credits and Other Liabilities
Deferred income tax (48,059) 256,882 1,069,518 - 1,278,341
Other deferred credits and liabilities 532,062 179,919 925,839 - 1,637,820
-----------------------------------------------------------------------------------------
484,003 436,801 1,995,357 - 2,916,161
-----------------------------------------------------------------------------------------
Capitalization
Common shareholders' equity 3,707,785 782,223 3,562,675 (4,382,027) 3,670,656
Preferred stock 83,568 - - - 83,568
Long-term debt 3,047,395 650,904 3,497,699 (1,584,566) 5,611,432
-----------------------------------------------------------------------------------------
Total Capitalization 6,838,748 1,433,127 7,060,374 (5,966,593) 9,365,656
-----------------------------------------------------------------------------------------
Minority Interest in Subsidiary Companies - - 509,549 - 509,549
-----------------------------------------------------------------------------------------
Total Liabilities & Capitalization $ 8,059,711 $ 2,167,863 $ 13,174,499 $ (8,761,891) $ 14,640,182
=========================================================================================
37
- ------------------------------------------------------------------------------------------------------------------------------------
Statement of Cash Flows
- ------------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30, 2004
----------------------------------------------------------------------------
Other
Guarantor KEDLI Subsidiaries Consolidated
----------------------------------------------------------------------------
Operating Activities
Net Cash Provided by Operating Activities $ (154,519) $ 198,606 $ 737,247 $ 781,334
----------------------------------------------------------------------------
Investing Activities
Capital expenditures - (76,341) (486,866) (563,207)
Cost of removal - (4,700) (16,549) (21,249)
Net proceeds from subsidiary stock transactions - 512,065 512,065
Net proceeds from sale/leaseback transaction - 383,716 383,716
Proceeds from sale of property - 13,138 13,138
----------------------------------------------------------------------------
Net Cash Provided by (Used in) Investing Activities - (81,041) 405,504 324,463
----------------------------------------------------------------------------
Financing Activities
Treasury stock issued 24,322 - - 24,322
Payment of debt, net (589,378) - (187,844) (777,222)
Common and preferred stock dividends paid (218,355) - - (218,355)
Gain on settlement of treasury lock 12,656 - - 12,656
Redemption of preferred stock (8,483) - - (8,483)
Other 3,878 - 12,953 16,831
Net intercompany accounts 906,574 (117,087) (789,487) -
-
----------------------------------------------------------------------------
Net Cash Provided by (Used in) Financing Activities 131,214 (117,087) (964,378) (950,251)
----------------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents $ (23,305) $ 478 $ 178,373 $ 155,546
Cash and Cash Equivalents at Beginning of Period 97,567 1,554 106,630 205,751
----------------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $ 74,262 $ 2,032 $ 285,003 $ 361,297
============================================================================
- -------------------------------------------------------------------------------------------------------------------------------
Statement of Cash Flows
- -------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30, 2003
-----------------------------------------------------------------------
Other
Guarantor KEDLI Subsidiaries Consolidated
-----------------------------------------------------------------------
Operating Activities
Net Cash Provided by Operating Activities $ 55,555 $ 86,851 $ 614,268 $ 756,674
-----------------------------------------------------------------------
Investing Activities
Capital expenditures - (82,233) (637,984) (720,217)
Other investments (50,500) (50,500)
Cost of removal - (1,708) (17,903) (19,611)
Proceeds from the sale of subsidiary investments 79,200 - 133,327 212,527
-----------------------------------------------------------------------
Net Cash Provided by (Used in) Investing Activities 79,200 (83,941) (573,060) (577,801)
-----------------------------------------------------------------------
Financing Activities
Treasury stock issued 76,984 - - 76,984
Equity issuance 473,573 - - 473,573
Redemption of promissory notes (447,005) - - (447,005)
Payment of debt, net 28,703 - (154,031) (125,328)
Redemption of preferred stock - - (14,293) (14,293)
Common and preferred stock dividends paid (208,178) - - (208,178)
Other 17,240 - (4,432) 12,808
Net intercompany accounts (142,833) (6,342) 149,175 -
-
-----------------------------------------------------------------------
Net Cash Provided by (Used in) Financing Activities (201,516) (6,342) (23,581) (231,439)
-----------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents $(66,761) $ (3,432) $ 17,627 $ (52,566)
Cash and Cash Equivalents at Beginning of Period 88,308 6,472 75,837 170,617
-----------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $ 21,547 $ 3,040 $ 93,464 $ 118,051
=======================================================================
38
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Consolidated Review of Results
- ------------------------------
The following is a summary of transactions affecting comparative earnings and a
discussion of material changes in revenues and expenses during the three and
nine months ended September 30, 2004, compared to the three and nine months
ended September 30, 2003. Capitalized terms used in the following discussion,
but not otherwise defined, have the same meaning as when used in the Notes to
the Consolidated Financial Statements included under Item 1. References to
"KeySpan," "we," "us," and "our" mean KeySpan Corporation, together with its
consolidated subsidiaries.
Operating income by segment, as well as consolidated earnings available for
common stock is set forth in the following table for the periods indicated.
- ----------------------------------------------------------------------------------------------------------------------------------
(In Thousands of Dollars, Except per Share)
- ----------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------------------------------------
Gas Distribution $ (23,627) $ (25,134) $ 391,090 $ 371,420
Electric Services 111,158 102,125 226,273 193,869
Energy Services
Operations (20,747) (15,498) (44,127) (35,083)
Goodwill impairment charge (122,229) - (122,229) -
Energy Investments
Operations 16,434 59,004 156,491 183,940
Ceiling test write-down - - (48,190) -
Eliminations and other 2,963 (12,574) 14,559 (11,300)
- ----------------------------------------------------------------------------------------------------------------------------------
Operating Income (Loss) (36,048) 107,923 573,867 702,846
Interest charges (88,308) (78,366) (260,848) (226,503)
Gain on Houston Exploration transaction - - 150,070 19,020
Gain (loss) on sale of KeySpan Canada - - 22,824 (30,345)
Cost of debt redemption (45,879) - (45,879) (24,094)
Other income and (deductions) 4,146 (9,569) (10,594) (25,472)
Income taxes (benefit) (50,310) 7,403 166,785 165,714
- ----------------------------------------------------------------------------------------------------------------------------------
Income (Loss) before change in accounting principle (115,779) 12,585 262,655 249,738
Cumulative effect of a change
in accounting principle - - - 174
- ----------------------------------------------------------------------------------------------------------------------------------
Net Income (Loss) (115,779) 12,585 262,655 249,912
Preferred stock dividend requirements 1,360 1,461 4,280 4,383
- ----------------------------------------------------------------------------------------------------------------------------------
Earnings (Loss) for Common Stock $(117,139) $ 11,124 $ 258,375 $ 245,529
- ----------------------------------------------------------------------------------------------------------------------------------
Basic Earnings per Share
Income (loss) before change in accounting principle $ (0.73) $ 0.07 $ 1.61 $ 1.56
Change in accounting principle - - - -
- ----------------------------------------------------------------------------------------------------------------------------------
$ (0.73) $ 0.07 $ 1.61 $ 1.56
- ----------------------------------------------------------------------------------------------------------------------------------
39
As indicated in the above table, earnings for common stock reflect a loss of
$117.1 million, or $0.73 per share, for the three months ended September 30,
2004, compared to earnings of $11.1 million, or $0.07 per share for the three
months ended September 30, 2003. Earnings for common stock for the nine months
ended September 30, 2004 were $258.4 million, or $1.61 per share, compared to
$245.5 million, or $1.56 per share, for the corresponding period last year.
KeySpan's financial results for the three and nine months ended September 30,
2004 and 2003 reflect a number of events that had a significant impact on
earnings.
In September 2004, KeySpan recorded a non-cash goodwill impairment charge of
$122.2 million ($90.4 million after - tax or $0.56 per share) as a result of an
evaluation of the carrying value of goodwill recorded in its Energy Services
segment. As prescribed in Statement of Financial Accounting Standards ("SFAS")
142 "Goodwill and Other Intangible Assets," KeySpan is required to compare the
fair value of a reporting unit to its carrying amount, including goodwill. This
evaluation is required to be performed at least annually, unless facts and
circumstances indicate that the evaluation should be performed at an interim
period during the year. Based upon the results through September 30, 2004
experienced by the Energy Services segment and management's opinion that it was
likely that a significant portion of the Energy Services segment will be sold
within the coming months, management concluded that KeySpan was required under
paragraph 28 of SFAS 142 to evaluate the goodwill recorded in the Energy
Services segment. This evaluation resulted in the impairment charge. (See Note
12 to the Consolidated Financial Statements "Goodwill Impairment" for further
details on this charge.)
In August 2004, KeySpan redeemed approximately $758 million of outstanding
long-term debt. KeySpan incurred $54.5 million in call premiums associated with
this redemption, of which $45.9 was expensed and recorded in other income and
deductions on the Consolidated Statement of Income. The remaining amount of the
call premiums have been deferred for future recovery. Further, KeySpan wrote-off
$8.2 million of previously deferred financing costs which have been reflected in
interest expense on the Consolidated Statement of Income. The total after-tax
expense of the debt redemption was $29.3 million or $0.18 per share. (See Note 9
to the Consolidated Financial Statements "Long-Term Debt and Commercial Paper"
for additional details on this transaction.) During the nine months ended
September 30, 2003, KeySpan incurred $24.1 million in debt redemption costs
associated with the redemption of approximately $447 million of outstanding
promissory notes that were issued to the Long Island Power Authority ("LIPA") in
connection with the KeySpan/Long Island Lighting Company ("LILCO") business
combination completed in May 1998, as well as costs incurred by The Houston
Exploration Company ("Houston Exploration"- our then 55% owned gas exploration
and production subsidiary) to retire $100 million 8.625% Notes. The total
after-tax expense of the debt redemptions was $13.6 million or $0.09 per share.
In June 2004, KeySpan exchanged 10.8 million shares of Houston Exploration
common stock for 100% of the stock of Seneca-Upshur Petroleum, Inc., a then
wholly-owned subsidiary of Houston Exploration. This transaction reduced our
interest in Houston Exploration from 55% to approximately 23.5% and resulted in
a gain to KeySpan of $150.1 million. Effective June 1, 2004, Houston
40
Exploration's earnings and our ownership interest in Houston Exploration have
been accounted for on the equity method of accounting. The deconsolidation of
Houston Exploration required the recognition of certain deferred taxes on our
remaining investment resulting in a deferred tax expense of $44.1 million.
Therefore, the net gain on the share exchange, less the deferred tax on the
remaining investment, was $106.0 million, or $0.66 per share. (See Note 2 to the
Consolidated Financial Statements "Business Segments" for a detailed discussion
of this transaction.)
On April 1, 2004, KeySpan and KeySpan Facilities Income Fund (the "Fund"), which
previously owned a 39.09% interest in KeySpan Canada (a KeySpan subsidiary with
natural gas processing plants and gathering facilities in Western Canada),
consummated a transaction whereby the Fund sold 15.617 million units of the
Fund. The Fund used the proceeds of the offering to acquire an additional 35.91%
interest in KeySpan Canada from KeySpan. As a result of the transaction, the
Fund's ownership in KeySpan Canada increased from 39.1% to 75% and KeySpan's
ownership of KeySpan Canada decreased to 25%. KeySpan recorded a gain of $22.8
million ($10.1 million after-tax, or $0.06 per share) on this transaction.
Effective April 1, 2004, KeySpan Canada's earnings and our ownership interest in
KeySpan Canada have been accounted for on the equity method of accounting.
In July 2004, the Fund issued an additional 10.7 million units, the proceeds of
which were used to fund the acquisition of the midstream assets of Chevron
Canada Midstream Inc. This transaction had the effect of further diluting
KeySpan's ownership of KeySpan Canada to 17.4%. (See Note 2 to the Consolidated
Financial Statements "Business Segments" for a detailed discussion of this
transaction.)
Asset transactions completed in 2003 also had a significant impact on
comparative earnings. These transactions included the monetization of a portion
of our ownership interests in Houston Exploration and KeySpan Canada. In
February 2003, we reduced our ownership interest in Houston Exploration from 66%
to approximately 55% following the repurchase, by Houston Exploration, of six
million shares of common stock owned by KeySpan. We recorded a gain of $19.0
million on this transaction, or $0.12 per share. Income taxes were not provided
on this transaction, since the transaction was structured as a return of
capital.
In June 2003, we sold 39.09% of our interest in KeySpan Canada and recorded a
pre-tax loss of $30.3 million ($34.1 million after applying applicable taxes or
$0.22 per share). Additionally, we sold our 20% interest in Taylor NGL LP that
owned and operated two extraction plants also in Canada.
As a result of these asset transactions, net income for the nine months ended
September 30, 2004, reflects a combined after-tax gain of $116.1 million or
$0.72 per share. Net income for the nine months ended September 30, 2003
reflects after-tax losses of $15.1 million or $0.10 per share.
41
In June 2004, KeySpan's wholly-owned gas exploration and production
subsidiaries, recorded a non-cash impairment charge of $48.2 million ($31.1
million after-tax, or $0.19 per share) to recognize the reduced valuation of
proved reserves. (See Note 10 to the Consolidated Financial Statements "Gas
Exploration and Production Property - Depletion for additional details on this
transaction.)
Operating income, as indicated in the above table, decreased $144 million and
$129 million for the three and nine months ended September 30, 2004,
respectively, compared to the corresponding periods last year. The decrease in
both periods primarily reflects the $122.2 million non-cash goodwill impairment
charge recorded in the Energy Services segment, and generally lower operating
results of this segment. Further, comparative operating income was adversely
impacted by lower operating income from the Energy Investment segment as a
result of the reduction in KeySpan's ownership interest in Houston Exploration
and KeySpan Canada, each of which are now accounted for on the equity method of
accounting. In addition, for the nine months ended September 30, 2004, operating
income in the Energy Investments segment was adversely impacted by the $48.2
million non-cash impairment charge to recognize the reduced valuation of proved
reserves. The higher comparative operating income in the Electric Services
segment for both the quarter and period ending September 30, 2004 primarily
reflects higher net electric margins associated with the Ravenswood Expansion,
(a recently constructed 250 MW combined cycle generating facility located at the
Ravenswood Facility site). In the Gas Distribution segment slightly lower
operating losses for the third quarter of 2004 primarily reflects lower
operating expenses, while for the nine months ended September 30, 2004 the Gas
Distribution segment benefited from customer additions and oil-to-gas
conversions throughout our service territories, as well as from a rate increase
resulting from the Boston Gas Company rate proceeding concluded last fall. (See
the discussion under the caption "Review of Operating Segments" for further
details on each segment.)
The increase in interest expense of $9.9 million, or 13%, and $34.3 million, or
15% for the three and nine months ended September 30, 2004, respectively,
compared to the same periods last year, reflects a number of items. As noted
earlier, interest expense for both the three and nine months ended September 30,
2004 includes the write-off of $8.2 million of previously deferred issuance
costs as a result of the redemption of $758 million of outstanding long-term
debt. In addition, interest expense in 2004 was impacted by the implementation
of FASB Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest
Entities, an Interpretation of ARB No. 51." This Interpretation required us to,
among other things, consolidate the Ravenswood Master Lease (the lease under
which KeySpan operates a portion of the Ravenswood electric generating
facilities) and classify the lease obligation as long-term debt on the
Consolidated Balance Sheet based on our current status as primary beneficiary.
As a result of implementing FIN 46, beginning January 1, 2004 lease payments
have been reflected as interest expense on the Consolidated Statement of Income
resulting in an increase to interest expense of $7.6 million and $22.4 million
for the quarter and nine months ended September 30, 2004, respectively. (See
Note 6 "Financial Guarantees and Contingencies for further information on the
Master Lease".)
42
Further, comparative interest expense for the nine months also reflects the
benefits realized in 2003 associated with interest rate swaps. In February 2003,
we terminated an interest rate swap agreement with a notional amount of $270
million. This swap was used to hedge a portion of outstanding promissory notes
that were issued to LIPA in connection with the KeySpan/LILCO business
combination. As noted previously, in March 2003, we called approximately $447
million of the outstanding promissory notes, and settled the outstanding
derivative instrument. The cash proceeds from the termination of the interest
rate hedge were $18.4 million, of which $8.1 million represented accrued swap
interest. The difference between the termination settlement amount and the
amount of accrued swap interest, $10.3 million, was recorded to earnings (as an
adjustment to interest expense) in the first quarter of 2003 and effectively
offset a portion of the redemption charges.
Offsetting, to some extent, these adverse impacts to comparative interest
expense are the benefits associated with a lower level of outstanding commercial
paper and long-term debt, as well as lower interest rates on outstanding
commercial paper.
In addition to the asset sales and debt redemption costs previously noted, other
income and (deductions) for the nine months ended September 30, 2004 reflects a
$12.6 million gain recorded on the settlement of a derivative financial
instrument entered into in connection with the sale/leaseback transaction
associated with the Ravenswood Expansion, as well as the effects of minority
interest of $37.0 million related to our previous controlling interests in
Houston Exploration and KeySpan Canada. (See Note 6 and Note 4 to the
Consolidated Financial Statements, "Financial Guarantees and Contingencies" and
"Hedging and Derivative Financial Instruments," for additional information
regarding the sale/leaseback transaction and derivative financial instrument.)
Other income and (deductions) for the nine months ended September 30, 2003 also
includes a $10.6 million severance tax refund for severance taxes paid in 2002
and earlier periods. The effects of minority interest of $19.9 million and $50.3
million for the three and nine months ended September 30, 2003 respectively, are
also reflected in other income and (deductions).
Income tax expense generally reflects the level of pre-tax income and, for the
nine months ended September 30, 2004, a $6.0 million benefit to income taxes
resulting from a revised appraisal associated with property that was disposed of
in 2003. Further, income tax expense for the nine months ended September 30,
2004 reflects the beneficial tax treatment afforded the stock transaction with
Houston Exploration.
Consistent with our prior earnings guidance, KeySpan's consolidated earnings for
2004 are forecasted to be in the range of $2.55 to $2.75 per share, excluding
special items. Earnings from continuing core operations (defined for this
purpose as all continuing operations other than exploration and production, less
preferred stock dividends) are forecasted to be in the range of $2.20 to $2.30
per share. Earnings from gas exploration and production operations, excluding
the impact of the gain on the sale of Houston Exploration and the impact of the
non-cash impairment charge, are forecasted to be in the range of $0.35 to $0.45
per share. The original non-core earnings forecast associated with gas
exploration and production activities remains in effect, as the favorable impact
of higher realized gas prices and production levels are offsetting the lower
ownership interest.
43
It should be noted that KeySpan's board of directors has approved an annual
dividend increase of 4 cents per share, effective upon the declaration of the
February 1, 2005 dividend.
Consolidated earnings are seasonal in nature due to the significant contribution
to earnings of the gas distribution operations. As a result, we expect to earn
most of our annual earnings in the first and fourth quarters of the fiscal year.
Review of Operating Segments
- ----------------------------
KeySpan's segment results are reported on an Operating Income basis. Management
believes that this Generally Accepted Accounting Principle (GAAP) based measure
provides a reasonable indication of KeySpan's underlying performance associated
with its operations. The following is a discussion of financial results achieved
by KeySpan's operating segments presented on an operating income basis.
Gas Distribution
KeySpan Energy Delivery New York ("KEDNY") provides gas distribution service to
customers in the New York City Boroughs of Brooklyn, Staten Island and a portion
of Queens, and KeySpan Energy Delivery Long Island ("KEDLI") provides gas
distribution service to customers in the Long Island counties of Nassau and
Suffolk and the Rockaway Peninsula of Queens County. Four gas distribution
companies - Boston Gas Company, Colonial Gas Company, Essex Gas Company, and
EnergyNorth Natural Gas Inc., each doing business under the name KeySpan Energy
Delivery New England ("KEDNE"), provide gas distribution service to customers in
Massachusetts and New Hampshire.
44
The table below highlights certain significant financial data and operating
statistics for the Gas Distribution segment for the periods indicated.
- -----------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------------------------
Revenues $ 419,208 $ 405,777 $ 3,023,350 $ 2,970,514
Cost of gas 186,619 173,116 1,776,322 1,744,732
Revenue taxes 7,211 10,191 52,260 66,077
- -----------------------------------------------------------------------------------------------------------------------------------
Net Revenues 225,378 222,470 1,194,768 1,159,705
- -----------------------------------------------------------------------------------------------------------------------------------
Operating Expenses
Operations and maintenance 148,816 163,372 489,357 492,586
Depreciation and amortization 63,381 59,996 207,131 197,005
Operating taxes 36,808 38,210 107,190 112,668
- -----------------------------------------------------------------------------------------------------------------------------------
Total Operating Expenses 249,005 261,578 803,678 802,259
- -----------------------------------------------------------------------------------------------------------------------------------
Gain on sale of property - 13,974 - 13,974
Operating Income $ (23,627) $ (25,134) $ 391,090 $ 371,420
- -----------------------------------------------------------------------------------------------------------------------------------
Firm gas sales and transportation (MDTH) 26,576 26,668 229,360 238,382
Transportation - Electric Generation (MDTH) 13,304 15,567 26,077 29,715
Other Sales (MDTH) 30,454 35,157 111,123 113,309
Warmer (Colder) than Normal - New York N/A N/A (3%) (13%)
Warmer (Colder) than Normal - New England N/A N/A (9%) (17%)
- -----------------------------------------------------------------------------------------------------------------------------------
Net Revenues
Net gas revenues (revenues less the cost of gas and associated revenue taxes)
from our gas distribution operations increased by $35.1 million, or 3%, for the
nine months ended September 30, 2004 compared to the same period last year. Net
gas revenues benefited from customer additions and oil-to-gas conversions, as
well as from a rate increase resulting from the Boston Gas Company's rate
proceeding that was concluded in the fourth quarter of 2003. As measured in
heating degree days, weather for the nine months ended September 30, 2004 in our
New York and New England service territories was approximately 3% and 9% colder
than normal, respectively, compared to approximately 13% and 17% colder than
normal last year, respectively. Weather was approximately 9% warmer than last
year across KeySpan's service territories.
Net revenues from firm gas customers (residential, commercial and industrial
customers) in our New York service territory increased $4.1 million for the nine
months ended September 30, 2004 compared to the same period last year. Customer
additions and oil-to-gas conversions, net of attrition and conservation, added
$1.8 million to net gas revenues. Further, we realized a $3.5 million benefit to
net gas revenues as a result of an additional billing day in the leap year and
$1.6 million associated with regulatory incentives. Weather, which was warmer
than last year, resulted in an adverse impact to comparative net gas revenues of
$3.3 million. KEDNY and KEDLI each operate under a utility tariff that contains
a weather normalization adjustment that significantly offsets variations in firm
net revenues due to fluctuations in normal weather. Since weather was colder
than normal we refunded to firm customers $8.8 million through the weather
normalization adjustment. Also included in net gas revenues is the recovery of
property taxes that added $0.5 million to net revenues during the period. These
revenues, however, do not impact net income since the taxes they are designed to
45
recover are expensed as amortization charges on the Consolidated Statement of
Income. Firm gas distribution rates for KEDNY and KEDLI during the first nine
months of 2004, other than for the recovery of gas costs, have remained
substantially unchanged from rates charged last year.
Net revenues from firm gas customers in our New England service territory
increased by $35.1 million during the first nine months of 2004 compared to the
same period last year. Customer additions and oil-to-gas conversions, net of
attrition and conservation, added $7.9 million to net gas revenues. Further, we
realized a $2.2 million benefit in net gas revenues as a result of an additional
billing day for leap year. As mentioned, the Massachusetts Department of
Telecommunications and Energy ("MA DTE") approved a $27 million base rate
increase for the Boston Gas Company, which became effective November 1, 2003.
For the nine months ended September 30, 2004, the rate increase resulted in a
benefit to net gas revenues of $27.3 million. (See the caption under "Regulation
and Rate Matters" for further information regarding the rate filing.) The gas
distribution operations of our New England based subsidiaries do not have a
weather normalization adjustment. Weather, which was warmer than last year,
resulted in an adverse impact to comparative net gas revenues of $10.1 million.
To mitigate the effect of fluctuations in normal weather patterns on KEDNE's
results of operations and cash flows, weather derivatives were in place for the
2003/2004 winter heating season (November through March). Since weather during
the first quarter of 2004 was approximately 9% colder than normal in the New
England service territories, we recorded a $4.1 million reduction to revenues to
reflect the loss on these derivative transactions. Similarly, in 2003 we
recorded an $11.9 million reduction to revenues. As a result of these
transactions, comparative net revenues were favorably impacted by $7.8 million.
(See Note 4 to the Consolidated Financial Statements "Hedging and Derivative
Financial Instruments" for further information.)
In our large-volume heating and other interruptible (non-firm) markets, which
include large apartment houses, government buildings and schools, gas service is
provided under rates that are designed to compete with prices of alternative
fuel, including No. 2 and No. 6 grade heating oil. These "dual-fuel" customers
can consume either natural gas or fuel oil for heating purposes. Net revenues in
these markets decreased $4.1 million during the nine months ended September 30,
2004 compared to the same period last year. The majority of interruptible
profits earned by KEDNE and KEDLI are returned to firm customers as an offset to
gas costs.
We are committed to our expansion strategies initiated during the past few
years. We believe that significant growth opportunities exist on Long Island and
in our New England service territories. We estimate that on Long Island
approximately 36% of the residential and multi-family markets, and approximately
58% of the commercial market, currently use natural gas for space heating.
Further, we estimate that in our New England service territories approximately
53% of the residential and multi-family markets, and approximately 63% of the
commercial market, currently use natural gas for space heating purposes. We will
continue to seek growth, in our market segments, through the expansion of our
gas distribution system, as well as through the conversion of residential homes
from oil-to-gas for space heating purposes and the pursuit of opportunities to
grow multi-family, industrial and commercial markets.
46
Firm Sales, Transportation and Other Quantities
Firm gas sales and transportation quantities for the nine months ended September
30, 2004, were approximately 4% lower compared to such quantities for same
period in 2003 reflecting the warmer weather. Net revenues are not affected by
customers opting to purchase their gas supply from other sources, since delivery
rates charged to transportation customers generally are the same as delivery
rates charged to full sales service customers. Transportation quantities related
to electric generation reflect the transportation of gas to our electric
generating facilities located on Long Island. Net revenues from these services
are not material.
Other sales quantities include on-system interruptible quantities, off-system
sales quantities (sales made to customers outside of our service territories)
and related transportation. We have an agreement with Coral Resources, L.P.
("Coral"), a subsidiary of Shell Oil Company, under which Coral assists in the
origination, structuring, valuation and execution of energy-related transactions
on behalf of KEDNY and KEDLI. We also have a portfolio management contract with
Entergy Koch Trading, LP ("EKT"), under which EKT provides all of the city gate
supply requirements at market prices and manages certain upstream capacity,
underground storage and term supply contracts for KEDNE. These agreements expire
on March 31, 2006.
Purchased Gas for Resale
The increase in gas costs for the nine months ended September 30, 2004 compared
to the same period of 2003 of $31.6 million, or 2%, reflects an increase of 8%
in the price per dekatherm of gas purchased, and a 5% decrease in the quantity
of gas purchased. The current gas rate structure of each of our gas distribution
utilities includes a gas adjustment clause, pursuant to which variations between
actual gas costs incurred for resale to firm sales customers and gas costs
billed to firm sales customers are deferred and refunded to or collected from
customers in a subsequent period.
Operating Expenses
Operating expenses during the third quarter of 2004 decreased $12.6 million or
5% compared to the same quarter last year. This decrease reflects lower
operations and maintenance expenses of $14.6 million, due in part, to a benefit
of approximately $2 million, net of amounts subject to regulatory deferral
treatment, associated with the implementation of the Medicare Prescription Drug
Improvement and Modernization Act of 2003 ("Medicare Act") and implementation of
Financial Accounting Standards Board Staff Position ("FSP") 106-2. (See Note 5
to the Consolidated Financial Statements "Recent Accounting Pronouncements" for
further information regarding the Act and FSP 106-2.) In addition, in September
2004, Boston Gas Company reached an agreement with an insurance carrier for
recovery of previously incurred environmental expenditures. Under a previously
issued MA DTE rate order, insurance and third-party recoveries, after deducting
legal fees, are shared between Boston Gas and its firm gas customers. As a
47
result of the insurance agreement, in September 2004 Boston Gas recorded a $5
million benefit to operations and maintenance expense. The remaining decrease in
operations and maintenance expense reflects lower costs associated with repair
and maintenance work. Higher depreciation and amortization expense reflects the
continued expansion of the gas distribution system.
Operating expenses for the nine months ended September 30, 2004 were essentially
the same as last year. Lower operations and maintenance costs of $3.2 million
reflect the environmental insurance settlement and the benefit attributable to
the Medicare Act as previously noted, as well as lower repair and maintenance
costs. These decreases to operations and maintenance expense were offset, in
part, by higher severance costs, as well as a higher provision for uncollectible
accounts receivable. Higher depreciation and amortization expense reflects the
continued expansion of the gas distribution system, while the lower operating
taxes resulted from a property tax refund in our New York service territory.
Sale of Property
During the third quarter of 2003, we recorded $14.0 million in gains from
property sales, primarily 550 acres of real property located on Long Island.
Other Matters
In order to serve the anticipated market requirements in our New York service
territories, KeySpan and Duke Energy Corporation formed Islander East Pipeline
Company, LLC ("Islander East") in 2000. Islander East is owned 50% by KeySpan
and 50% by Duke Energy, and was created to pursue the authorization and
construction of an interstate pipeline from Connecticut, across Long Island
Sound, to a terminus near Shoreham, Long Island. Applications for all necessary
regulatory authorizations were filed in 2000 and 2001. Islander East has
received a final certificate from the Federal Energy Regulatory Commission
("FERC") and all necessary permits from the State of New York. The State of
Connecticut denied Islander East's applications for coastal zone management and
Section 401 of the Clean Water Act authorizations. Islander East appealed the
State of Connecticut's determination on the coastal zone management issue to the
United States Department of Commerce. On May 6, 2004, the Department of Commerce
overrode Connecticut's denial and granted the coastal zone management
authorization. Islander East's petition for a declaratory order challenging the
denial of the Section 401 authorization is pending with Connecticut's State
Superior Court. Once in service, the pipeline is expected to transport up to
260,000 DTH daily to the Long Island and New York City energy markets, enough
natural gas to heat 600,000 homes. The pipeline will also allow KeySpan to
diversify the geographic sources of its gas supply. Various options for the
financing of this pipeline construction are currently being evaluated. At
September 30, 2004, our investment in the Islander East pipeline was $19.1
million.
48
Electric Services
The Electric Services segment primarily consists of subsidiaries that own and
operate oil and gas-fired electric generating plants in the Borough of Queens
(including the "Ravenswood Projects") and the counties of Nassau and Suffolk on
Long Island. In addition, through long-term contracts of varying lengths, we
manage the electric transmission and distribution ("T&D") system, the fuel and
electric purchases, and the off-system electric sales for LIPA. The Electric
Services segment also provides retail marketing of electricity to commercial
customers, the earnings of which were previously reported in the Energy Services
segment. Financial results for 2003 have been reclassified to reflect these
activities in the Electric Services segment.
Selected financial data for the Electric Services segment is set forth in the
table below for the periods indicated.
- ---------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003 2004 2003
- ---------------------------------------------------------------------------------------------------------------------------
Revenues $ 503,879 $ 438,602 $ 1,296,778 $ 1,228,698
Purchased fuel 175,906 132,520 407,613 381,116
- ---------------------------------------------------------------------------------------------------------------------------
Net Revenues 327,973 306,082 889,165 847,582
- ---------------------------------------------------------------------------------------------------------------------------
Operating Expenses
Operations and maintenance 153,712 151,678 472,880 495,873
Depreciation 21,590 16,492 65,556 49,300
Operating taxes 41,513 35,787 124,456 108,540
- ---------------------------------------------------------------------------------------------------------------------------
Total Operating Expenses 216,815 203,957 662,892 653,713
- ---------------------------------------------------------------------------------------------------------------------------
Operating Income $ 111,158 $ 102,125 $ 226,273 $ 193,869
- ---------------------------------------------------------------------------------------------------------------------------
Electric sales (MWH)* 2,177,030 1,854,740 4,807,667 3,617,522
Capacity(MW)* 2,450 2,200 2,450 2,200
Cooling degree days 751 824 1,051 1,000
- ---------------------------------------------------------------------------------------------------------------------------
*Reflects the operations of the Ravenswood Projects only.
Net Revenues
Total electric net revenues realized during the third quarter of 2004 were $21.9
million, or 7% higher than such revenues realized during the third quarter of
2003. For the nine months ended September 30, 2004, total electric net revenues
were $41.7 million, or 5% higher than the same period last year. The increase in
both the quarter and nine months ended September 30, 2004, is attributable to
the operations of the Ravenswood Expansion.
Net revenues from the Ravenswood Projects increased $14.2 million, or 13% in the
third quarter of 2004 compared to the third quarter of 2003. Comparative net
revenues reflect increased energy margins of $6.4 million, as well as higher
capacity revenues of $7.8 million.
49
For the nine months ended September 30, 2004, net revenues from the Ravenswood
Projects reflect a $38.3 million, or 16% increase over the same period last
year. Comparative net revenues reflect increased energy margins of $26.3
million, as well as higher capacity revenues of $12.0 million.
The increase in capacity revenues for both the quarter and period ending
September 30, 2004 compared to the corresponding periods last year primarily
reflect the operations of the Ravenswood Expansion. (See the discussion below
under "Other Matters" for a description of the Ravenswood Expansion.)
The increase in energy margins for both the quarter and nine months ended
September 30, 2004, reflects a higher level of megawatt hours ("MWh") sold into
the New York Independent System Operator ("NYISO") energy market, while
"spark-spreads" (the selling price of electricity less the cost of fuel, plus
hedging gains or losses) remained essentially constant. The increase in energy
sales quantities reflects the operations of the Ravenswood Expansion. As
measured in cooling degree-days, weather during the third quarter of 2004 was
approximately 9% cooler than the same quarter last year and approximately 11%
cooler than normal. For the nine months ended September 30, 2004, weather was
approximately 5% warmer compared to the same period in 2003. Further, energy
sales quantities for the nine months ended September 30, 2003 were adversely
impacted by the scheduled major overhaul of our largest electric generating unit
during the first quarter of 2003.
We employ derivative financial hedging instruments to hedge the cash flow
variability for a portion of forecasted purchases of natural gas and fuel oil
consumed at the Ravenswood Projects. Further, we have engaged in the use of
derivative financial hedging instruments to hedge the cash flow variability
associated with a portion of forecasted peak electric energy sales from the
Ravenswood Projects. These derivative instruments resulted in hedging gains,
which are reflected in net electric margins, of $21.4 million for the quarter
ended September 30, 2004, compared to hedging gains of $8.5 million for the
quarter ended September 30, 2003. For the nine months ended September 30, 2004
derivative instruments resulted in net hedging gains of $18.7 million compared
to hedging gains of $10.3 million for the same period in 2003. The benefits
derived from KeySpan's hedging strategy contributed to consistent spark-spreads
for all periods reported despite the cooler weather. (See Note 4 to the
Consolidated Financial Statements "Hedging and Derivative Financial Instruments"
as well as Item 3. Quantitative and Qualitative Disclosures about Market Risk
for further information").
The rules and regulations for capacity, energy sales and the sale of certain
ancillary services to the NYISO energy markets continue to evolve and the FERC
has adopted several price mitigation measures that have adversely impacted
earnings from the Ravenswood Facility over time and more recently the Ravenswood
Expansion. Certain of these mitigation measures are still subject to rehearing
and possible judicial review. The final resolution of these issues and their
effect on our financial position, results of operations and cash flows cannot be
fully determined at this time. (See the caption "Market and Credit Risk
Management Activities" for a further discussion of these matters. Also see
KeySpan's 2003 Annual Report on Form 10-K for the Year Ended December 31, 2003
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations under the caption "Market and Credit Risk Management Activities.)
50
Net revenues from the service agreements with LIPA, including the power purchase
agreements associated with two electric peaking facilities, increased $9.1
million for the three months ended September 30, 2004, compared to the same
period last year. This increase reflects, in part, recovery from LIPA of
approximately $6 million in higher property taxes and depreciation charges.
These recoveries had no impact on operating income since actual property taxes
and depreciation charges increased by a like amount. The remaining increase of
approximately $3 million in comparative revenues reflects the beneficial impact
from the timing of certain cost recoveries, partially offset by lower energy
margins that are shared with LIPA. This variation does impact operating income.
Net revenues from the service agreements with LIPA, including the power purchase
agreements associated with two electric peaking facilities, increased $5.3
million for the nine months ended September 30, 2004, compared to the same
period last year. This increase reflects, in part, recovery from LIPA of
approximately $18 million in higher property taxes and depreciation charges. As
mentioned, these recoveries had no impact on operating income since actual
property taxes and depreciation charges increased by a like amount. Further,
comparative revenues reflect adjustments to the cost recovery mechanism in the
LIPA Service Agreements to better align actual costs incurred with recovery of
such costs. These adjustments reduced revenues during the nine months ended
September 30, 2004 by approximately $12 million compared to the same period last
year. These adjustments to revenues had no impact on operating income since
actual operating costs decreased by a like amount. Excluding these two items,
net revenues from the service agreements with LIPA decreased approximately $0.7
million for the nine months ended September 30, 2004, compared to the same
period last year. The slight reduction in net revenues reflects lower energy
margins that are shared with LIPA, offset by the beneficial impact from the
timing of certain cost recoveries.
For a description of the LIPA Service Agreements and power purchase agreements,
see KeySpan's 2003 Annual Report on Form 10-K for the Year Ended December 31,
2003 Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations under the caption "Electric Services - Revenue
Mechanisms.")
Operating Expenses
Operating expenses increased $12.9 million, or 6%, in the third quarter of 2004
compared to the same quarter of 2003. The increase in operations and maintenance
expense of $2.0 million primarily reflects lease costs of $4.5 million
associated with the sale/leaseback transaction involving the Ravenswood
Expansion that went into effect May 2004, as well as an increase in repair and
maintenance cost, including removal costs, associated with the Ravenswood
Projects. These expenses were partially offset by KeySpan's implementation of
FIN 46 which required KeySpan to consolidate the Ravenswood Master Lease and
classify the lease obligation as long-term debt on the Consolidated Balance
Sheet. Further, an asset was recorded on the Consolidated Balance Sheet for an
amount substantially equal to the fair market value of the leased assets at the
inception of the lease, less depreciation since that date. As a result of
implementing FIN 46, beginning January 1, 2004, lease payments associated with
51
the Ravenswood Master Lease have been reflected as interest expense on the
Consolidated Statement of Income and the leased assets are being depreciated.
The reclassification of lease payments to interest expense resulted in a
comparative decrease to operations and maintenance expense of $7.6 million. (See
Note 6 to the Consolidated Financial Statements "Financial Guarantees and
Contingencies" for additional information regarding KeySpan's leasing
arrangements.)
The increase in depreciation expense of $5.1 million primarily relates to the
depreciation of the leased assets under the Ravenswood Master Lease which
increased depreciation by $4.1 million. The remaining increase in depreciation
expense is associated with KeySpan's Long Island based electric generating units
and are fully recoverable from LIPA. The higher operating taxes primarily
reflect an increase in property taxes which are fully recoverable from LIPA as
noted earlier.
Operating expenses increased $9.2 million, or 1%, during the nine months ended
September 30, 2004 compared to the same period of 2003 due to higher operating
taxes and depreciation charges, partially offset by lower operations and
maintenance expenses. Operations and maintenance expense decreased $23.0 million
reflecting, in part, $12 million in lower costs associated with the LIPA Service
Agreements as noted earlier. The remaining decrease in operations and
maintenance expense is primarily due to the impact of FIN 46. The
reclassification of lease payments associated with the Ravenswood Master Lease
to interest expense resulted in a comparative decrease to operations and
maintenance expense of $22.4 million. However, KeySpan incurred lease costs of
$6.0 million associated with the sale/leaseback transaction involving the
Ravenswood Expansion as well as increased repair and maintenance costs,
including removal costs, associated with the Ravenswood Projects, which
partially offset the beneficial impact of FIN 46.
The increase in depreciation expense of $16.3 million primarily relates to the
depreciation of the leased assets under the Ravenswood Master Lease which
increased depreciation by $12.3 million. The remaining increase in depreciation
expense is associated with KeySpan's Long Island based electric generating units
and are fully recoverable from LIPA. The higher operating taxes primarily
reflect an increase in property taxes which are fully recoverable from LIPA, as
noted earlier.
Other Matters
The Ravenswood Expansion, a 250 MW combined cycle generating facility, was
synchronized to the electric grid in December 2003 and commenced operational
testing in January 2004. In March, the facility completed full load Dependable
Maximum Net Capacity testing and in May 2004 the facility began full commercial
operations. The entire capacity and energy produced from this plant is being
sold into the NYISO markets.
To finance this facility, KeySpan entered into a leveraged lease financing
arrangement. In May 2004, the facility was acquired by a lessor from our
subsidiary, KeySpan Ravenswood, LLC, and simultaneously leased back to it. All
the obligations of our subsidiary under the lease have been unconditionally
guaranteed by KeySpan. This lease transaction generated cash proceeds of $385
52
million, before transaction costs, which approximates the fair market value of
the facility, as determined by a third-party appraiser. The lease has an initial
term of 36 years and the yearly operating lease expense will be approximately
$17 million per year. Lease payments will fluctuate from year to year, but are
substantially paid over the first 16 years. (See Note 6 to the Consolidated
Financial Statements, "Financial Guarantees and Contingencies" for additional
information regarding this financing arrangement.)
In 2003, the New York State Board on Electric Generation Siting and the
Environment issued an opinion and order which granted a certificate of
environmental capability and public need for a 250 MW combined cycle electric
generating facility in Melville, Long Island, which is now final and
non-appealable. Also in 2003, LIPA issued a Request for Proposal ("RFP") seeking
bids from developers to either build and operate a Long Island generating
facility, and/or a new cable that will link Long Island to dedicated off-Long
Island power of between 250 to 600 MW of electricity by no later than the summer
of 2007. KeySpan and American National Power Inc. ("ANP") filed a joint proposal
in response to LIPA's RFP. Under the proposal, KeySpan and ANP would have
jointly owned and operated two 250 MW electric generating facilities to be
located on Long Island, one of which is the Melville site and the other in the
town of Brookhaven which also has received all permits and approvals. In May
2004, LIPA tentatively selected proposals submitted by two other bidders in
response to the RFP. KeySpan remains committed to the Melville project and the
benefits to Long Island's energy future that this project would supply. We will
continue to explore specific options for this facility. At September 30, 2004,
total capitalized costs associated with the siting, permitting and procurement
of equipment for the Melville facility were approximately $58.1 million. Energy
Services
The Energy Services segment includes subsidiaries that provide energy-related
services to customers primarily located within the Northeastern United States,
with concentrations in the New York City metropolitan area including New Jersey,
as well as Rhode Island, Pennsylvania, Massachusetts and New Hampshire, through
the following lines of business: (i) Home Energy Services, which provides
residential and small commercial customers with service and maintenance of
energy systems and appliances; (ii) Business Solutions, which provides plumbing,
heating, ventilation, air conditioning and mechanical services, as well as
operation and maintenance, design, engineering and consulting services to
commercial and industrial customers.
The table below highlights selected financial information for the Energy
Services segment.
- --------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------------------
Revenues $ 125,752 $ 139,887 $ 392,271 $ 404,188
Less: cost of sales 112,754 118,807 325,385 334,257
- --------------------------------------------------------------------------------------------------------------------------------
Gross profit 12,998 21,080 66,886 69,931
Operating expenses (33,745) (36,578) (111,013) (105,014)
Goodwill impairment charge (122,229) - (122,229) -
- --------------------------------------------------------------------------------------------------------------------------------
Operating (Loss) $ (142,976) $ (15,498) $ (166,356) $ (35,083)
- --------------------------------------------------------------------------------------------------------------------------------
53
The Energy Services segment incurred operating losses of $143 million for the
third quarter of 2004 compared to losses of $15.5 million for the same quarter
last year. For the nine months ended September 30, 2004, the Energy Services
segment realized operating losses of $166.4 million compared to $35.1 million
for the same period last year. As noted earlier, in September 2004, KeySpan
recorded a non-cash goodwill impairment charge of $122.2 million ($90.4 million
after - tax or $0.56 per share) as a result of an evaluation of the carrying
value of goodwill recorded in this segment. Based upon the operating results
experienced in this segment through September 30, 2004, excluding the impairment
charge, and management's opinion that it was likely that a significant portion
of the Energy Services segment will be sold within the coming months, management
concluded that KeySpan was required to evaluate the goodwill at this interim
period. This evaluation resulted in the aforementioned non-cash impairment
charge. Approximately $50 million of goodwill remains in this segment. (See Note
12 to the Consolidated Financial Statements "Goodwill Impairment" for further
details on this charge.)
Lower operating results for the three months ended September 30, 2004 compared
to the same quarter last year, excluding the goodwill impairment charge,
reflects lower gross profit margin estimates on certain Business Solutions
projects. Lower operating results for the nine months ended September 30, 2004
compared to the same period last year, excluding the goodwill impairment charge,
was due to higher operating expenses. The increase in operating expenses
principally reflects the write-off of accounts receivable and contract revenues
on certain projects that were deemed to be uncollectible, as well as the
write-down of inventory balances. Further, gross margin profitability in this
segment was adversely impacted by increased cost estimates on certain Business
Solutions projects.
Energy Investments
The Energy Investment segment consists of our gas exploration and production
operations, as well as certain other domestic and international energy-related
investments. Our gas exploration and production subsidiaries include our
approximate 23.5% ownership interest in The Houston Exploration Company
("Houston Exploration"), as well as our wholly-owned subsidiaries KeySpan
Exploration and Production LLC ("KeySpan Exploration and Production") and
Seneca-Upshur Petroleum, Inc. These companies are engaged in gas and oil
exploration and production, and the development and acquisition of domestic
natural gas and oil properties.
As mentioned earlier, in June 2004, KeySpan exchanged 10.8 million shares of
Houston Exploration common stock for 100% of the stock of Seneca-Upshur
Petroleum, Inc., then a wholly owned subsidiary of Houston Exploration. This
transaction reduced our interest in Houston Exploration from 55% to the current
level of 23.5%. As part of this transaction, Houston Exploration, retired 4.6
million of its common shares and issued 6.8 million new shares in a public
offering. Based on Houston Exploration's announced offering price of $48.00 per
share, Seneca-Upshur's shares were valued at the equivalent of $449 million, or
$41.57 per share. Seneca-Upshur's assets consisted of West Virginia producing
properties valued at $60 million, and $389 million in cash. This transaction
54
resulted in a gain to KeySpan of $150.1 million. Effective June 1, 2004, Houston
Exploration's earnings and our ownership interest in Houston Exploration have
been accounted for on the equity method of accounting. The deconsolidation of
Houston Exploration required the recognition of certain deferred taxes on our
remaining investment resulting in a deferred tax expense of $44.1 million.
Therefore, the net gain on the share exchange, less the deferred tax provision
on the remaining investment, was $106.0 million, or $0.66 per share.
Selected financial data and operating statistics for our gas exploration and
production activities are set forth in the following table for the periods
indicated. Operating income below represents 100% of our gas exploration and
production subsidiaries' results for the five months ended May 31, 2004 and four
month of equity earnings for our 23.5% interest in Houston Exploration.
- -----------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------------------------
Revenues $ 4,975 $ 123,052 $ 276,320 $ 373,774
Less: Depletion and amortization expense 1,279 48,641 107,738 145,559
Full cost ceiling test write-down - - 48,190 -
Other operating expenses 1,704 23,416 47,449 71,482
Plus: Equity earnings 10,340 - 12,885 -
- -----------------------------------------------------------------------------------------------------------------------------------
Operating Income $ 12,332 $ 50,995 $ 85,828 $ 156,733
- -----------------------------------------------------------------------------------------------------------------------------------
The decline in operating income of $38.7 million for the three months ended
September 30, 2004 and $70.9 million for the nine months ended September 30,
2004, compared to the corresponding periods in 2003, reflects the reduction in
KeySpan's ownership interest in Houston Exploration. As mentioned earlier, in
2003 KeySpan maintained a 55% ownership interest in Houston Exploration compared
to an approximate 23.5% interest since June 2, 2004. Further, the reduction in
operating income for the nine months ended September 30, 2004 reflects the $48.2
million non-cash impairment charge recorded by KeySpan's wholly-owned gas
exploration and production subsidiaries to reflect the reduced valuation of
proved reserves. (See Note 10 to the Consolidated Financial Statements "Gas
Exploration and Production Property - Depletion" for further details on the
impairment charge.)
Seneca-Upshur utilizes over-the-counter ("OTC") natural gas index swaps to hedge
the cash flow variability associated with forecasted sales of a portion of its
natural gas production. At September 30, 2004, Seneca-Upshur has hedge positions
in place for approximately 85% of its estimated remaining 2004 gas production,
net of gathering related costs. Further, Seneca-Upshur has hedge positions in
place for approximately 85% of its estimated 2005 through 2007 gas production,
net of gathering costs. We use forward index prices to value these swap
positions. (See Note 4 to the Consolidated Financial Statements "Hedging and
Derivative Financial Instruments" for further details on the derivative
financial instruments.)
This segment also consists of KeySpan Canada; our 20% interest in Iroquois Gas
Transmission System LP ("Iroquois"); our wholly-owned 600,000 barrel liquefied
natural gas ("LNG") storage and receiving facility located in Rhode Island
("KeySpan LNG"); and our 50% interest in Premier Transmission Limited located in
Northern Ireland. In addition this segment has ownership interests in two
proposed gas pipelines.
55
In April 2004, KeySpan and KeySpan Facilities Income Fund, which previously
owned a 39.09% interest in KeySpan Canada, (the "Fund") entered into a
transaction whereby the Fund sold 15.617 million units of the Fund at a price of
CDN$12.60 per unit for gross total proceeds of approximately CDN$196.8 million.
The proceeds of the offering were used by the Fund to acquire an additional
35.91% interest in KeySpan Canada (a KeySpan subsidiary with natural gas
processing plants and gathering facilities in Western Canada) from KeySpan. We
received net proceeds of approximately CDN$186.3 million (or approximately
US$135 million), after commissions and expenses. As a result of the transaction
the Fund's ownership in KeySpan Canada was increased from 39.1% to 75% and
KeySpan's ownership of KeySpan Canada decreased to 25%. KeySpan recorded a gain
of $22.8 million ($10.1 million after-tax, or $0.06 per share) on this
transaction. Effective April 1, 2004, KeySpan Canada's earnings and our
ownership interest in KeySpan Canada have been accounted for on the equity
method of accounting.
In July 2004, the Fund issued an additional 10.7 million units, the proceeds of
which were used to fund the acquisition of the midstream assets of Chevron
Canada Midstream Inc. This transaction had the effect of further diluting
KeySpan's ownership of KeySpan Canada to 17.4%.
Selected financial data and operating statistics for these energy-related
investments are set forth in the following table for the periods indicated.
Operating income below represents 100% of KeySpan Canada's results for three
months ended March 31, 2004 and six months of equity earnings since April 2004.
- -----------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------------------------
Revenues $ 5,066 $ 27,699 $ 41,631 $ 84,043
Less: Operation and maintenance expense 5,498 16,709 28,077 52,743
Other operating expenses 1,339 5,708 8,538 16,471
Plus: Equity earnings 5,873 2,727 17,457 12,378
- -----------------------------------------------------------------------------------------------------------------------------------
Operating Income $ 4,102 $ 8,009 $ 22,473 $ 27,207
- -----------------------------------------------------------------------------------------------------------------------------------
The decrease in comparative operating income for both the quarter and nine
months ended September 30, 2004 compared to same periods last year reflects our
lower ownership interest in KeySpan Canada. Operating income from our other
energy-related investments in 2004 was substantially the same as 2003.
We have stated in the past that we may sell or otherwise dispose of certain
Energy Investments assets. Based on current market conditions, however, we
cannot predict when, or if, additional sales or dispositions of these assets may
take place, or the effect that any such additional sale or disposition may have
on our financial position, results of operations or cash flows.
56
Allocated Costs
We are subject to the jurisdiction of the Securities and Exchange Commission
("SEC") under the Public Utility Holding Company Act ("PUHCA") as amended. As
part of the regulatory provisions of PUHCA, the SEC regulates various
transactions among affiliates within a holding company system. In accordance
with the SEC's regulations under PUHCA and the New York State Public Service
Commission, we have service companies that provide: (i) traditional corporate
and administrative services; (ii) gas and electric transmission and distribution
systems planning, marketing, and gas supply planning and procurement; and (iii)
engineering and surveying services to subsidiaries. Operating income variations
reflected in "eliminations and other" associated with these non-operating
subsidiaries reflect, in part, allocation adjustments recorded in 2003. As
required by the SEC, during the third quarter of 2003 we adjusted certain
provisions in our allocation methodology that resulted in certain costs being
allocated back to certain non-operating subsidiaries. Further, operating income
variations are also due to the timing of certain corporate allocations.
Liquidity
Cash flow from operating activities increased $24.7 million, or 3%, for the nine
months ended September 30, 2004 compared to the same time last year, reflecting
the consolidation our newly created "captive" insurance company, which included
$43.2 million of cash and short-term marketable securities. Comparative cash
flow from operating activities also reflects the favorable impact of the timing
of certain property tax payments, offset by lower cash flow from gas exploration
and production activities due to the lower ownership interest.
KeySpan currently has funds invested outside the United States. We intend to
repatriate approximately $200 million as a result of the passage, on October 26,
2004, of the American Jobs Creation Act of 2004. A significant provision of this
Act as it relates to KeySpan is the 85% dividend deduction for dividends
received from foreign corporations. The Act will allow KeySpan to
tax-effectively bring these funds back into the United States.
At September 30, 2004, we had cash and temporary cash investments of $361.3
million. During the nine months ended September 30, 2004, we borrowed $93.5
million of commercial paper and, at September 30, 2004, $575.4 million of
commercial paper was outstanding at a weighted-average annualized interest rate
of 1.9%. We had the ability to borrow up to an additional $725 million at
September 30, 2004, under the terms of our credit facility.
In June 2004, KeySpan completed the restructuring of its credit facilities. We
entered into a new $640 million five year revolving credit facility to replace
the $450 million, 364 day facility which expired in June. We also amended our
existing three year $850 million facility due June 2006 to reduce commitments
thereunder by $190 million to a new level of $660 million. The two credit
facilities total $1.3 billion and are each syndicated among sixteen banks. These
facilities continue to support KeySpan's commercial paper program for working
capital needs.
57
The fees for these facilities are subject to a ratings-based grid, with an
annual fee of 0.08% on the new five-year facility and 0.125% on the existing
three-year facility. Both credit agreements allow for KeySpan to borrow using
several different types of loans; specifically, Eurodollar loans, Adjustable
Bank Rate (ABR) loans, or competitively bid loans. Eurodollar loans in the
five-year facility are based on the Eurodollar rate plus a margin of 0.40% for
loans up to 33% of the total five-year facility, and an additional 0.125% for
loans over 33% of the total five-year facility. In the three-year facility
Eurodollar loans are based on the Eurodollar rate plus a margin of 0.625% for
loans up to 33% of the total three-year facility, and an additional 0.125% for
loans over 33% of the total three-year facility. ABR loans are based on the
highest of the Prime Rate, the base CD rate plus 1%, or the Federal Funds
Effective Rate plus 0.5%. Competitive bid loans are based on bid results
requested by KeySpan from the lenders. We do not anticipate borrowing against
these facilities; however, if the credit rating on our commercial paper program
were to be downgraded, it may be necessary to do so.
The facilities contain certain affirmative and negative operating covenants,
including restrictions on KeySpan's ability to mortgage, pledge, encumber or
otherwise subject its property to any lien, as well as certain financial
covenants that require us to, among other things, maintain a consolidated
indebtedness to consolidated capitalization ratio of no more than 64% until the
expiration of the existing three-year facility in 2006, at which time it will be
lowered to 62%. Violation of this covenant could result in the termination of
the facilities and the required repayment of amounts borrowed thereunder, as
well as possible cross defaults under other debt agreements.
Under the terms of the credit agreements, KeySpan's debt-to-total capitalization
ratio reflects 80% equity treatment for the MEDS Equity Units issued in May
2002. At September 30, 2004, consolidated indebtedness, as calculated under the
terms of the credit agreements was 52.6% of consolidated capitalization.
Houston Exploration and KeySpan Canada also have revolving credit facilities
with commercial banks. During the time period that Houston Exploration's results
were consolidated with KeySpan's (the five months ended May 31, 2004) Houston
Exploration borrowed $49 million under its credit facility and repaid $136
million. KeySpan Canada repaid $17.7 million under its facility during the first
three months of 2004 (the time period in which its results were consolidated
with KeySpan's). These borrowings and repayments are included in the
Consolidated Cash Flow Statement. Cash borrowings and repayments under Houston
Exploration's and KeySpan Canada's credit facilities after the date of the stock
transactions are not reflected in the Consolidated Cash Flow Statement.
A substantial portion of consolidated revenues are derived from the operations
of businesses within the Electric Services segment, that are largely dependent
upon two large customers - LIPA and the NYISO. Additionally, our KEDNE gas
supply is concentrated with Entergy-Koch Trading. Accordingly, our cash flows
are dependent upon the timely payment or delivery of amounts or commodity owed
to us by these counterparties.
58
We satisfy our seasonal working capital requirements primarily through
internally generated funds and the issuance of commercial paper. We believe that
these sources of funds are sufficient to meet our seasonal working capital
needs.
Capital Expenditures and Financing
Construction Expenditures
The table below sets forth our construction expenditures by operating segment
for the periods indicated:
- -----------------------------------------------------------------------------
Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003
- -----------------------------------------------------------------------------
- -----------------------------------------------------------------------------
Gas Distribution $ 295,995 $ 274,702
Electric Services 104,443 200,425
Energy Investments 150,586 235,322
Energy Services and other 12,183 9,768
- -----------------------------------------------------------------------------
$ 563,207 $ 720,217
- -----------------------------------------------------------------------------
Construction expenditures related to the Gas Distribution segment are primarily
for the renewal, replacement and expansion of the distribution system.
Construction expenditures for the Electric Services segment reflect costs: (i)
to maintain our generating facilities; and (ii) construct the Ravenswood
Expansion. Construction expenditures related to the Energy Investments segment
primarily reflect costs associated with gas exploration and production
activities, including those of Houston Exploration through May 31, 2004, as well
as costs related to KeySpan Canada's gas processing facilities through April 1,
2004.
Financing
In August 2004, KeySpan redeemed approximately $758 million of outstanding debt.
KeySpan incurred $54.5 million in call premiums associated with this redemption,
of which $45.9 million was expensed and recorded in other income and deductions
on the Consolidated Statement of Income. The remaining call premiums have been
deferred for future recovery. Further, KeySpan wrote-off $8.2 million of
previously deferred financing costs which have been reflected in interest
expense on the Consolidated Statement of Income. (See Note 9 to the Consolidated
Financial Statements "Long-Term Debt and Commercial Paper for additional details
of this transaction.)
Also during the third quarter of 2003, KEDNY retired a portion, $8.0 million, of
its outstanding Gas Facilities Revenue Bonds. The funds used to retire this debt
were drawn from a special deposit defeasance trust previously established by
KEDNY. Approximately $640 million of Gas Facilities Revenue Bonds remain
outstanding.
59
In August 2004, KeySpan redeemed 83,268 shares of preferred stock 6.00% Series A
par value $100 that were previously issued in a private placement. KeySpan
redeemed these shares at a 2% premium and incurred a cash expenditure of $8.5
million.
During the second quarter of 2004, KeySpan entered into a leveraged lease
financing arrangement associated with the Ravenswood Expansion. In May 2004, the
facility was acquired by a lessor from our subsidiary, KeySpan Ravenswood, LLC,
and simultaneously leased back to that subsidiary. All of the obligations of our
subsidiary under the lease have been unconditionally guaranteed by KeySpan. This
lease transaction generated cash proceeds of $385 million, before transaction
costs, which approximates fair market value of the facility, as determined by a
third-party appraiser. (See Note 6 to the Consolidated Financial Statements,
"Financial Guarantees and Contingencies" for additional information regarding
this financing arrangement.)
In October, KeySpan filed a new universal shelf Registration Statement to issue,
from time to time, up to $3 billion in securities. We will continue to evaluate
our capital structure and financing strategy for the remainder of 2004 and
beyond.
The following table represents the ratings of our long-term debt at September
30, 2004. Currently, Standard & Poor's and Moody's Investor Services ratings on
KeySpan's and its subsidiaries' long-term debt are on negative outlook.
- -----------------------------------------------------------------------------------------------
Moody's Investor Standard
Services & Poor's FitchRatings
- -----------------------------------------------------------------------------------------------
KeySpan Corporation A3 A A-
KEDNY N/A A+ A+
KEDLI A2 A+ A-
Boston Gas A2 A N/A
Colonial Gas A2 A+ N/A
KeySpan Generation A3 A N/A
- -----------------------------------------------------------------------------------------------
Off-Balance Sheet Arrangements
Guarantees
KeySpan has a number of financial guarantees with its subsidiaries that have
remained substantially unchanged since December 31, 2003. At September 30, 2004,
KeySpan had fully and unconditionally guaranteed: (i) $525 million of
medium-term notes issued by KEDLI; (ii) the obligations of KeySpan Ravenswood
LLC, which is the lessee under the $425 million Master Lease associated with the
Ravenswood Facility and the lessee under the sale/leaseback transaction; and
(iii) the payment obligations of our subsidiaries related to $128 million of
tax-exempt bonds issued through the Nassau County and Suffolk County Industrial
Development Authorities for the construction of two electric-generation peaking
facilities on Long Island. The medium-term notes, the Master Lease and the
tax-exempt bonds are reflected on the Consolidated Balance Sheet; the
sale/leaseback transaction is not recorded on the Consolidated Balance Sheet.
Further, KeySpan has guaranteed: (i) up to $269 million of surety bonds
60
associated with certain construction projects currently being performed by
subsidiaries within the Energy Services segment; (ii) certain supply contracts,
margin accounts and purchase orders for certain subsidiaries in an aggregate
amount of $77 million; and (iii) $74 million of subsidiary letters of credit.
These guarantees are not recorded on the Consolidated Balance Sheet. At this
time, we have no reason to believe that our subsidiaries will default on their
current obligations. However, we cannot predict when or if any defaults may take
place or the impact such defaults may have on our consolidated results of
operations, financial condition or cash flows. (See Note 6 to the Consolidated
Financial Statements, "Financial Guarantees and Contingencies" for additional
information regarding KeySpan's guarantees.)
Contractual Obligations
KeySpan has certain contractual obligations related to its outstanding long-term
debt, outstanding credit facility borrowings, outstanding commercial paper
borrowings, operating and capital leases, and demand charges associated with
certain commodity purchases. Except for the recent sale/leaseback transaction
associated with the Ravenswood Expansion and the recent debt redemption, both
previously noted, these obligations have remained substantially unchanged since
December 31, 2003. Cash obligations associated with the sale/leaseback
transaction are anticipated to be: (i) $2.7 million for the remainder of 2004;
(ii) $69.4 million for fiscal years 2005 through 2007; (iii) $73.4 million for
fiscal years 2008 and 2009; and (iv) $465.1 million thereafter. Cash interest
savings as a result of the recent debt redemption are estimated to be (i) $13.9
million for the remainder of 2004; (ii) $65.3 million for fiscal years 2005
through 2007; (iii) $9.3 million for fiscal years 2008 and 2009; and (iv) $53.2
million thereafter. (For additional details regarding these obligations see
KeySpan's Annual Report on Form 10-K for the Year Ended December 31, 2003, Item
7 Management's Discussion and Analysis of Financial Condition and Results of
Operations, Note 6 "Long-Term Debt," as well as Note 7 to those Consolidated
Financial Statements "Contractual Obligations, Financial Guarantees and
Contingencies.")
Discussions of Critical Accounting Policies and Assumptions
In preparing our financial statements, the application of certain accounting
policies requires difficult, subjective and/or complex judgments. The
circumstances that make these judgments difficult, subjective and/or complex
have to do with the need to make estimates about the impact of matters that are
inherently uncertain. Actual effects on our financial position and results of
operations may vary significantly from expected results if the judgments and
assumptions underlying the estimates prove to be inaccurate. At September 30,
2004, KeySpan's critical accounting policies and assumptions have remained
substantially unchanged since December 31, 2003. Below is a brief discussion of
those critical accounting policies requiring such subjectivity. For a more
detailed discussion of these policies and assumptions see KeySpan's Annual
Report on Form 10-K for the Year Ended December 31, 2003, Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations
"Discussion of Critical Accounting Policies and Assumptions."
61
Percentage of Completion Accounting
Percentage-of-completion accounting is a method of accounting for long-term
construction type contracts in accordance with Generally Accepted Accounting
Principles and, accordingly, the method used for engineering and mechanical
contracting revenue recognition by the Energy Services segment. Due to
uncertainties inherent within estimates employed to apply
percentage-of-completion accounting, it is possible that estimates will be
revised as project work progresses. Changes in estimates resulting in additional
future costs to complete projects can result in reduced margins or loss
contracts.
Valuation of Goodwill
KeySpan records goodwill on purchase transactions, representing the excess of
acquisition cost over the fair value of net assets acquired. In testing for
goodwill impairment under SFAS 142 "Goodwill and Other Intangible Assets",
significant reliance is placed upon a number of estimates regarding future
performance that require broad assumptions and significant judgment by
management. A change in the fair value of our investments could cause a
significant change in the carrying value of goodwill.
In connection with the preparation of third quarter financial statements,
KeySpan conducted an evaluation of the carrying value of goodwill recorded in
its Energy Services segment. As prescribed in SFAS 142, KeySpan is required to
compare the fair value of a reporting unit to its carrying amount, including
goodwill. This evaluation is required to be performed at least annually, unless
facts and circumstances indicated that the evaluation should be performed at an
interim period during the year. Prior to this evaluation, the recorded goodwill
for the Energy Services segment, as a result of prior acquisitions, was
approximately $173 million.
As a result of an extremely competitive market and slugish economic conditions
within the construction industry in the Northeastern United States, the Energy
Services segment has experienced significantly lower operating profits and cash
flows than originally projected. As previously reported, management has been
reviewing the operating performance of this segment.. At a meeting held on
November 2, 2004, KeySpan's Board of Directors authorized management to begin
the process of disposing of a significant portion of its ownership interests in
certain companies within the Energy Services segment - specifically those
companies engaged in mechanical contracting activities. For the nine months
ended September 30, 2004, the mechanical contracting activities contributed
approximately 60% of the revenues recorded in the Energy Services segment.
Based upon the results through September 30, 2004 experienced by the Energy
Services segment and management's opinion that it was likely that a significant
portion of the Energy Services segment will be sold within the coming months,
specifically the mechanical contracting companies, management concluded that
KeySpan was required to evaluate the goodwill recorded in the Energy Services
segment.
As a result of this interim evaluation, KeySpan recorded a non-cash goodwill
impairment charge of $122.2 million ($90.4 million or $0.56 per share) in
September 2004. KeySpan employed a combination of two methodologies in
determining the estimated fair value for its investment in the Energy Services
segment, a market valuation approach and an income valuation approach. Under the
market valuation approach, KeySpan utilized a range of near-term potential
realizable values for the mechanical contracting businesses. Under the income
valuation approach, the fair value was obtained by discounting the sum of (i)
the expected future cash flows and (ii) the terminal value. KeySpan was required
to make certain significant assumptions, specifically the weighted-average cost
of capital, short and long-term growth rates and expected future cash flows.
Therefore, the significant assumptions used in this interim evaluation may
change in future evaluations.
In addition, we will continue to evaluate the fair value of the mechanical
contracting companies in relation to potential disposition alternatives and
their carrying value. As a result of this evaluation we may also be required to
write-down the carrying value of the mechanical contracting companies in an
amount that can not currently be determined.
62
At this point in time, we are unable to predict if any additional impairment
charges may be required for this segment, the timing of any such charges, the
impact any such charges would have on our financial position and results of
operations, or the timing of any sales of our ownership interest in certain
companies operating in this segment. (See Note 12 to the Consolidated Financial
Statements "Goodwill Impairment" for further details.)
Accounting for the Effects of Rate Regulation on Gas Distribution Operations
The financial statements of the Gas Distribution segment reflect the ratemaking
policies and orders of the New York State Public Service Commission ("NYPSC"),
the New Hampshire Public Utility Commission ("NHPUC"), and the MA DTE.
Four of our six regulated gas utilities (KEDNY, KEDLI, Boston Gas Company and
EnergyNorth Natural Gas, Inc.) are subject to the provisions of SFAS 71,
"Accounting for the Effects of Certain Types of Regulation." This statement
recognizes the actions of regulators, through the ratemaking process, to create
future economic benefits and obligations affecting rate-regulated companies.
In separate merger-related orders issued by the MA DTE, the base rates charged
by Colonial Gas Company and Essex Gas Company have been frozen at their current
levels for a ten-year period ending 2009. Due to the length of these base rate
freezes, the Colonial and Essex Gas Companies had previously discontinued the
application of SFAS 71.
As is further discussed under the caption "Regulation and Rate Matters," the
rate plans previously in effect for KEDNY and KEDLI have expired. The continued
application of SFAS 71 to record the activities of these subsidiaries is
contingent upon the actions of regulators with regard to future rate plans. We
are currently evaluating various options that may be available to us including,
but not limited to, proposing new plans for KEDNY and KEDLI. The ultimate
resolution of any future rate plans could have a significant impact on the
application of SFAS 71 to these entities and, accordingly, on our financial
position, results of operations and cash flows. However, management believes
63
that currently available facts support the continued application of SFAS 71 and
that all regulatory assets and liabilities are recoverable or refundable through
the regulatory environment. It should be noted that the MA DTE approved a base
revenue increase for the Boston Gas Company in the fourth quarter of 2003. (See
the discussion under the caption "Regulation and Rate Matters" for additional
information regarding the DTE's rate decision.)
Rate regulation is undergoing significant change as regulators and customers
seek lower prices for utility service and greater competition among energy
service providers. In the event that regulation significantly changes the
opportunity for us to recover costs in the future, all or a portion of our
regulated operations may no longer meet the criteria for the application of SFAS
71. In that event, a write-down of our existing regulatory assets and
liabilities could result. In management's opinion, our regulated subsidiaries
that currently are subject to the provisions of SFAS 71 will continue to be
subject to SFAS 71 for the foreseeable future.
Pension and Other Postretirement Benefits
KeySpan participates in both non-contributory defined benefit pension plans, as
well as other post-retirement benefit ("OPEB") plans (collectively
"postretirement plans"). KeySpan's reported costs of providing pension and OPEB
benefits are dependent upon numerous factors resulting from actual plan
experience and assumptions of future experience. Pension and OPEB costs
(collectively "postretirement costs") are impacted by actual employee
demographics, the level of contributions made to the plans, earnings on plan
assets, and health care cost trends. Changes made to the provisions of these
plans may also impact current and future postretirement costs. Postretirement
costs may also be significantly affected by changes in key actuarial
assumptions, including anticipated rates of return on plan assets and the
discount rates used in determining the postretirement costs and benefit
obligations. Actual results that differ from our assumptions are accumulated and
amortized over ten years.
Historically, we have funded our qualified pension plans in excess of the amount
required to satisfy minimum ERISA funding requirements. At September 30, 2004,
we had a funding credit balance in excess of the ERISA minimum funding
requirements. Although we have presently exceeded ERISA funding requirements,
our pension plans, on an actuarial basis, are currently underfunded. Therefore,
for 2004, KeySpan expects to contribute a total of $142 million to its funded
and unfunded post-retirement plans. Future funding requirements are heavily
dependent on actual return on plan assets and prevailing interest rates and may
vary from prior estimates. (In addition to Item 7 Management's Discussion and
Analysis of Financial Condition and Results of Operations in KeySpan's Annual
Report on Form 10-K for the Year Ended December 31, 2003, see also Note 4 of
those Consolidated Financial Statements, "Postretirement Benefits.")
Full Cost Accounting
Our gas exploration and production subsidiaries use the full cost method to
account for their natural gas and oil properties. Under full cost accounting,
all costs incurred in the acquisition, exploration, and development of natural
gas and oil reserves plus asset retirement obligations are capitalized into a
"full cost pool." Capitalized costs include costs of all unproved properties,
internal costs directly related to natural gas and oil activities, and
capitalized interest.
64
Under full cost accounting rules, total capitalized costs are limited to a
ceiling equal to the present value of future net revenues, discounted at 10%,
plus the lower of cost or fair value of unproved properties less income tax
effects (the "ceiling limitation"). A quarterly ceiling test is performed to
evaluate whether the net book value of the full cost pool exceeds the ceiling
limitation. If capitalized costs (net of accumulated depreciation, depletion and
amortization) less deferred taxes are greater than the discounted future net
revenues or ceiling limitation, a write-down or impairment of the full cost pool
is required. At June 30, 2004, such a write-down was required for our
wholly-owned gas exploration and production subsidiaries' full cost pool and we
recorded a non-cash impairment charge of $48.2 million. (See Note 10 to the
Consolidated Financial Statements "Gas Exploration and Production Property -
Depletion" for additional details regarding this charge.)
Natural gas and oil reserve quantities represent estimates only. Under full cost
accounting, reserve estimates are used to determine the full cost ceiling
limitation as well as the depletion rate. Our gas exploration and production
subsidiaries estimate proved reserves and future net revenues using sales prices
estimated to be in effect as of the date it makes the reserve estimates.
Further, our subsidiaries employ independent petroleum engineers in the
preparation of estimated reserve quantities. Natural gas prices, which have
fluctuated widely in recent years, affect estimated quantities of proved
reserves and future net revenues. Any estimates of natural gas and oil reserves
and their values are inherently uncertain, including many factors beyond our
control.
Accounting for Sales of Stock by a Subsidiary
KeySpan applies the accounting principle of income recognition for gains or
losses associated with the sale of stock by its subsidiaries. As provided for in
Staff Accounting Bulletin Topic 5-H ("SAB 51"), the SEC allows for income
recognition of gains or losses on subsidiary stock transactions in instances
where the transaction is not part of a broader corporate reorganization
contemplated by the parent. Provided that no other capital transactions are
contemplated with regard to the shares issued, income statement treatment in
consolidation for issuance of stock by a subsidiary is appropriate. SAB 51
requires that this accounting treatment, if elected by the parent, must be
consistently applied to all subsidiary stock transactions that meet the
conditions for income statement recognition. As noted earlier, KeySpan has
appropriately applied this accounting treatment to its recent subsidiary stock
transactions.
Regulation and Rate Matters
Gas Matters
As of September 30, 2004, the rate agreements for KEDNY and KEDLI have expired.
Under the terms of the KEDNY and KEDLI rate agreements, gas distribution rates
and all other provisions will remain in effect until changed by the NYPSC. At
this time, we are currently evaluating various options that may be available to
us regarding the KEDNY and KEDLI rate plans, including but not limited to,
proposing new rate plans.
65
Effective November 1, 2003, the MA DTE approved a $25.9 million increase in base
revenues for the Boston Gas Company with an allowed return on equity of 10.2%
reflecting an equal balance of debt and equity. On January 27, 2004, the MA DTE
issued its order on Boston Gas Company's Motion for Recalculation,
Reconsideration and Clarification that granted an additional $1.1 million in
base revenues, for a total of $27 million. The MA DTE also approved a
Performance Based Rate Plan (the "Plan") for up to ten years. On October 29,
2004, the MA DTE approved a base rate increase of $4.6 million under the Plan.
In addition, an increase of $7.9 million in the local distribution adjustment
clause was approved to recover pension and other postretirement costs.
For an additional discussion of our current gas distribution rate agreements,
see KeySpan's Annual Report on Form 10-K for the Year Ended December 31, 2003,
Item 7 Management's Discussion and Analysis of Financial Condition and Results
of Operations "Regulation and Rate Matters."
Electric Matters
KeySpan sells to LIPA all of the capacity and, to the extent requested, energy
conversion services from our existing Long Island based oil and gas-fired
generating plants. Sales of capacity and energy conversion services are made
under rates approved by the Federal Energy Regulatory Commission ("FERC") in
accordance with the Power Supply Agreement ("PSA") entered into between KeySpan
and LIPA in 1998. The prior FERC approved rates, which had been in effect since
May 1998, expired on December 31, 2003. KeySpan filed with the FERC an updated
cost of service for the Long Island based generating plants in October 2003. The
rate filing included, among other things, an annual revenue increase of 2.1% or
approximately $6.4 million, a return on equity of 11%, updated operating and
maintenance expense levels and recovery of certain other costs. FERC approved
implementation of new rates starting January 1, 2004, subject to refund.
Settlement negotiations with LIPA concluded in September 2004 and on October 1,
2004 the FERC approved the settlement reached between KeySpan and LIPA. Under
the new Settlement Agreement, KeySpan is entitled to a return on equity of 9.5%
with no revenue increase. The FERC approved updated operating and maintenance
expense levels and recovery of certain other costs as agreed to by the parties.
Securities and Exchange Commission Regulation
KeySpan and certain of its subsidiaries are subject to the jurisdiction of the
SEC under PUHCA. The rules and regulations under PUHCA generally limit the
operations of a registered holding company to a single integrated public utility
system, plus additional energy-related businesses. In addition, the principal
regulatory provisions of PUHCA: (i) regulate certain transactions among
affiliates within a holding company system including the payment of dividends by
such subsidiaries to a holding company; (ii) govern the issuance, acquisition
and disposition of securities and assets by a holding company and its
subsidiaries; (iii) limit the entry by registered holding companies and their
subsidiaries into businesses other than electric and/or gas utility businesses;
and (iv) require SEC approval for certain utility mergers and acquisitions. As a
result of the recent transactions with Houston Exploration and KeySpan Canada,
these entities are no longer subject to SEC jurisdiction under PUHCA.
66
KeySpan has the authorization, under PUHCA to do the following through December
31, 2006 (the "Authorization Period"): (a) to issue and sell up to an additional
amount of $3.0 billion of common stock, preferred stock, preferred and
equity-linked securities, and long-term debt securities (the "Long-Term
Financing Limit") in accordance with certain defined parameters; (b) in addition
to the Long-Term Financing Limit, to issue and sell up to an aggregate amount of
$1.3 billion of short-term debt; (c) to issue up to 13 million shares of common
stock under dividend reinvestment and stock-based management incentive and
employee benefit plans; (d) to maintain existing and enter into additional
hedging transactions with respect to outstanding indebtedness in order to manage
and minimize interest rate costs; (e) to issue guarantees and other forms of
credit support in an aggregate principal amount not to exceed $4.0 billion
outstanding at any one time; (f) to refund, repurchase (through open market
purchases, tender offers or private transactions), replace or refinance debt or
equity securities outstanding during the Authorization Period through the
issuance of similar or any other type of authorized securities; (g) to pay
dividends out of capital and unearned surplus as well as paid-in-capital with
respect to certain subsidiaries, subject to certain limitations; (h) to engage
in preliminary development activities and administrative and management
activities in connection with anticipated investments in exempt wholesale
generators, foreign utility companies and other energy-related companies; (i) to
organize and/or acquire the equity securities of entities that will serve the
purpose of facilitating authorized financings; (j) to invest up to $3.0 billion
in exempt wholesale generators and foreign utility companies; (k) to create
and/or acquire the securities of entities organized for the purpose of
facilitating investments in other non-utility subsidiaries; and (l) to enter
into certain types of affiliate transactions between certain non-utility
subsidiaries involving cost structures above the typical "at-cost" limit.
In addition, we have committed that during the Authorization Period, our common
equity will be at least 30% of our consolidated capitalization and each of our
utility subsidiaries' common equity will be at least 30% of such entity's
capitalization. At September 30, 2004, KeySpan's consolidated common equity was
43% of its consolidated capitalization, including commercial paper, and each of
its utility subsidiaries common equity was at least 40% of its respective
capitalization.
On October 1, 2004, in accordance with its PUHCA authorization, KeySpan filed a
new universal shelf registration statement on Form S-3 with the SEC for the
issuance from time to time of up to $3.0 billion in securities.
Environmental Matters
KeySpan is subject to various federal, state and local laws and regulatory
programs related to the environment. We estimate that the remaining cost of our
manufactured gas plant ("MGP") related environmental cleanup activities,
including costs associated with the Ravenswood facility, will be approximately
$247.5 million and we have recorded a related liability for such amount. We have
also recorded an additional $22.0 million liability representing the estimated
environmental cleanup costs related to a former coal tar processing facility.
Further, as of September 30, 2004, we have expended a total of $124.5 million on
environmental remediation. (See Note 6 to the Consolidated Financial Statements,
"Financial Guarantees and Contingencies".)
67
Market and Credit Risk Management Activities
Market Risk: KeySpan is exposed to market risk arising from potential changes in
one or more market variables, such as energy commodity prices, interest rates,
foreign currency exchange rates, volumetric risk due to weather or other
variables. Such risk includes any or all changes in value whether caused by
commodity positions, asset ownership, business or contractual obligations, debt
covenants, exposure concentration, currency, weather, and other factors
regardless of accounting method. We manage our exposure to changes in market
prices using various risk management techniques for non-trading purposes,
including hedging through the use of derivative instruments, both
exchange-traded and over-the-counter contracts, purchase of insurance and
execution of other contractual arrangements.
KeySpan is exposed to price risk due to investments in equity and debt
securities held to fund benefit payments for various employee pension and other
postretirement benefit plans. To the extent that the value of investments held
change, or long-term interest rates change, the effect will be reflected in
KeySpan's recognition of periodic cost of such employee benefit plans and the
determination of the amount of cash to be contributed to the employee benefit
plans.
Credit Risk: KeySpan is exposed to credit risk arising from the potential that
our counterparties fail to perform on their contractual obligations. Our credit
exposures are created primarily through the sale of gas and transportation
services to residential, commercial, electric generation, and industrial
customers and the provision of retail access services to gas marketers, by our
regulated gas businesses; the sale of commodities and services to LIPA and the
NYISO; the sale of gas, power and services to our retail customers by our
unregulated energy service businesses; entering into financial and energy
derivative contracts with energy marketing companies and financial institutions;
and the sale of gas, natural gas liquids, oil and processing services to energy
marketing and oil and gas production companies.
We have regional concentration of credit risk due to receivables from
residential, commercial and industrial customers in New York, New Hampshire and
Massachusetts, although this credit risk is spread over a diversified base of
residential, commercial and industrial customers. Customers' payment records are
monitored and action is taken, when appropriate. Companies within the Energy
Services segment have a concentration of credit risk to large customers and to
the governmental and healthcare industries.
We also have concentrations of credit risk from LIPA, our largest customer, and
from other energy and financial services companies. Concentration of
counterparty credit risk may impact overall exposure to credit risk in that our
counterparties may be similarly impacted by changes in economic, regulatory or
other considerations. We actively monitor the credit profile of our wholesale
counterparties in derivative and other contractual arrangements, and manage our
level of exposure accordingly. In instances where counterparties' credit quality
has declined, or credit exposure exceeds certain levels, we may limit our credit
exposure by restricting new transactions with the counterparty, requiring
additional collateral or credit support and negotiating the early termination of
certain agreements.
68
Regulatory Issues and Competitive Environment: We are subject to various other
risk exposures and uncertainties associated with our gas and electric
operations. The most significant contingency involves the evolution of the gas
distribution and electric industries towards more competitive and deregulated
environments. These risks have not changed substantially since December 31,
2003. The following discussion is an update to the issues discussed in KeySpan's
Annual Report on Form 10-K for the Year Ended December 31, 2003.
Gas and electric Retail Competition
New York and Long Island
The NYPSC continues to conduct collaborative proceedings on ways to develop the
competitive energy markets in New York. On July 13, 2001, the presiding officers
in the case (the "Commission") issued their recommended decision ("RD"). At that
time, the Commission set a timeframe of three to five years for the exit of
utilities from the merchant function. Basic rate design issues were also
established.
For the last several years, the Commission has been monitoring the progress of
competition in the energy market. Based upon its findings of the current market
and its continued desire to move toward fully competitive markets, the
Commission, in August 2004, issued a second policy statement. The underlying
vision remains unchanged. The items of importance in the new policy include:
o Elimination of a timeframe for the exit of utilities from the merchant
function. Experience, time and maturation of each market/customer class
will dictate the exit of utilities
o Acknowledgement that competitive commodity markets for the largest
customers has occurred. However, workable competition for the mass markets
(i.e. residential and small commercial customers) is taking longer and
needs to be nurtured.
o Future rate filings must include a plan for facilitating customer migration
to competitive markets and a fully embedded cost of service study that
develops unbundled rates for the utility's delivery service and all
potentially competitive services
o Utilities should avoid entering into long term capacity arrangements unless
it is necessary for reliability and safety purposes
o Where markets are not workably competitive, the Commission must ensure that
rates continue to be just and reasonable, and protect customers from price
volatility.
69
Electric Industry
Due to volatility in the market clearing price of 10-minute spinning and
non-spinning reserves during the first quarter of 2000, the NYISO requested that
FERC approve a bid cap on reserves as well as requiring a refunding of so called
alleged "excess payments" received by sellers, including Ravenswood. On May 31,
2000, FERC issued an order that granted approval of a $2.52 per MWh bid cap for
10 minute non-spinning reserves, plus payments for the opportunity cost of not
making energy sales. The other requests, such as a bid cap for spinning
reserves, retroactive refunds, recalculation of reserve prices for March 2000,
and convening a technical conference and settlement proceeding, were rejected.
The NYISO, Con Edison, Niagara Mohawk Power Corporation and Rochester Gas and
Electric each individually appealed FERC's order to Federal court. The appeals
were consolidated into one case by the court. On November 7, 2003 the United
States Court of Appeals for the District of Columbia (the "Court") issued its
decision in the case of Consolidated Edison Company of New York, Inc., v.
Federal Energy Regulatory Commission ("Decision"). Essentially, the Court found
errors in the Commission's decision and remanded some issues in the case back to
the Commission for further explanation and action. The FERC has not acted on the
remand.
On June 25, 2004, the NYISO submitted a motion to FERC seeking refunds as a
result of the Decision. KeySpan and others submitted statements of opposition
opposing the refunds. FERC has not acted on the remand or the NYISO's refund
motion and we cannot predict the outcome of these proceedings.
For additional information regarding these risks see KeySpan's Annual Report on
Form 10-K for the Year Ended December 31, 2003, Item 7 Management's Discussion
and Analysis of Financial Condition and Results of Operations "Market and Credit
Risk Management Activities."
Cautionary Statement Regarding Forward-Looking Statements
Certain statements contained in this Quarterly Report on Form 10-Q concerning
expectations, beliefs, plans, objectives, goals, strategies, future events or
performance and underlying assumptions and other statements that are other than
statements of historical facts, are "forward-looking statements" within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended.
Without limiting the foregoing, all statements under the captions "Item 2.
Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Item 3. Quantitative and Qualitative Disclosures About Market
Risk" relating to our future outlook, anticipated capital expenditures, future
cash flows and borrowings, pursuit of potential future acquisition opportunities
and sources of funding, are forward-looking statements. Such forward-looking
statements reflect numerous assumptions and involve a number of risks and
uncertainties and actual results may differ materially from those discussed in
such statements.
Among the factors that could cause actual results to differ materially are:
- - volatility of energy prices used to generate electricity;
- - fluctuations in weather and in gas and electric prices;
70
- - general economic conditions, especially in the Northeast United States;
- - our ability to successfully manage our cost structure and operate
efficiently;
- - our ability to successfully contract for natural gas supplies required to
meet the needs of our customers;
- - implementation of new accounting standards;
- - inflationary trends and interest rates;
- - the ability of KeySpan to identify and make complementary acquisitions, as
well as the successful integration of recent and future acquisitions;
- - available sources and cost of fuel;
- - creditworthiness of counterparties to derivative instruments and commodity
contracts;
- - the resolution of certain disputes with LIPA concerning each party's rights
and obligations under various agreements;
- - retention of key personnel;
- - federal and state regulatory initiatives that increase competition,
threaten cost and investment recovery, and place limits on the type and
manner in which we invest in new businesses and conduct operations;
- - the impact of federal and state utility regulatory policies and orders on
our regulated and unregulated businesses;
- - potential write-down of our investment in natural gas properties when
natural gas prices are depressed or if we have significant downward
revisions in our estimated proved gas reserves;
- - competition facing our unregulated Energy Services businesses, including
but not limited to competition from other mechanical, plumbing, heating,
ventilation and air conditioning, and engineering companies, as well as,
other utilities and utility holding companies that are permitted to engage
in such activities;
- - the degree to which we develop unregulated business ventures, as well as
federal and state regulatory policies affecting our ability to retain and
operate such business ventures profitably;
- - changes in political conditions, acts of war or terrorism;
- - changes in rates of return on overall debt and equity markets could have an
adverse impact on the value of pension assets;
- - changes in accounting standards or GAAP which may require adjustment to
financial statements;
71
- - a change in the fair value of our investments that could cause a
significant change in the carrying value of goodwill;
- - timely receipts of payments from our two largest customers LIPA and the
NYISO; and
- - other risks detailed from time to time in other reports and other documents
filed by KeySpan with the SEC.
For any of these statements, KeySpan claims the protection of the safe harbor
for forward-looking information contained in the Private Securities Litigation
Reform Act of 1995, as amended. For additional discussion on these risks,
uncertainties and assumptions, see "Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations."
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Financially-Settled Commodity Derivative Instruments - Hedging Activities: From
time to time, KeySpan subsidiaries have utilized derivative financial
instruments, such as futures, options and swaps, for the purpose of hedging the
cash flow variability associated with changes in commodity prices. KeySpan is
exposed to commodity price risk primarily with regard to its gas distribution
operations, gas exploration and production activities and its electric
generating facilities. Our gas distribution operations utilize natural gas and
fuel oil swaps to hedge the cash-flow variability of specified portions of gas
purchases and sales associated with certain large-volume customers. Derivative
financial instruments are employed by Houston Exploration to hedge cash flow
variability associated with forecasted sales of natural gas. However, since
Houston Exploration is no longer a consolidated subsidiary its derivative
financial instruments are not reflected on the September 30, 2004 Consolidated
Balance Sheet. Seneca-Upshur utilizes over-the-counter ("OTC") natural gas index
swaps to hedge cash flow variability associated with forecasted sales of natural
gas. The Ravenswood Projects use derivative financial instruments to hedge the
cash flow variability associated with the purchase of a portion of natural gas
and oil that will be consumed during the generation of electricity. The
Ravenswood Projects also hedge the cash flow variability associated with a
portion of peak electric energy sales.
KeySpan uses standard NYMEX futures prices to value gas futures and heating oil
contracts and market quoted forward prices to value oil swap and natural gas
basis swap contracts associated with its Ravenswood Projects and certain
large-volume customers of our gas distribution operations. We also use market
quoted forward prices to value electric derivatives associated with the
Ravenswood Projects. Seneca-Upshur uses forward index prices to value its OTC
swaps.
72
The following tables set forth selected financial data associated with these
derivative financial instruments noted above that were outstanding at September
30, 2004.
- -----------------------------------------------------------------------------------------------------------------------------------
Year of Volumes Fixed Current Fair Value
Type of Contract not updated Maturity mmcf Price $ Price $ ($000)
- -----------------------------------------------------------------------------------------------------------------------------------
Gas
Swaps/Futures - Long Natural Gas 2004 2,759 5.59 - 6.18 6.80 - 7.64 3,673
2005 2,749 6.74 - 7.01 7.99 - 8.03 3,048
OTC Swaps - Short Natural Gas 2004 338 5.99 7.06 - 7.91 (499)
2005 695 6.58 6.68 - 8.33 (1,065)
2006 1,884 6.17 6.07 - 7.32 (449)
2007 1,812 5.86 5.53 - 6.71 4
- -----------------------------------------------------------------------------------------------------------------------------------
10,237 4,712
- -----------------------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------------------
Year of Volumes Fixed Current Fair Value
Type of Contract Maturity Barrels Price $ Price $ ($000)
- ---------------------------------------------------------------------------------------------------------------------------------
Oil
Swaps - Long Fuel Oil 2004 34,000 24.85 - 34.40 34.00 - 35.60 180
2005 84,000 24.65 - 34.40 35.21 - 36.36 347
2006 12,000 30.80 - 34.40 34.15 - 35.41 25
Swaps - Short Heating Oil 2004 628,038 49.98 - 50.19 58.21 - 58.25 (5,098)
2005 765,451 52.63 - 55.23 57.31 - 58.13 (2,963)
- ---------------------------------------------------------------------------------------------------------------------------------
1,523,489 (7,509)
- ---------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------
Year of Fixed Margin/ Current Fair Value
Type of Contract Maturity MWh Price $ Price $ ($000)
- ------------------------------------------------------------------------------------------------------------------------------
Electricity
Swaps - Energy 2004 389,600 27.48 - 72.00 33.33 - 81.25 2,988
2005 806,400 29.95 - 101.50 35.29 - 100.13 (710)
- ------------------------------------------------------------------------------------------------------------------------------
1,196,000 2,278
- ------------------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------
2004
Change in Fair Value of Derivative Instruments ($000)
- ---------------------------------------------------------------------------
Fair value of contracts at January 1, 2004 $ (36,224)
Losses on contracts realized 3,979
Derivative balance that has been de-consolidated 14,331
(Decrease) in fair value of all open contracts 17,395
- ---------------------------------------------------------------------------
Fair value of contracts outstanding at September 30, 2004 $ (519)
- ---------------------------------------------------------------------------
73
- ---------------------------------------------------------------------------------------------------
(In Thousands of Dollars)
- ---------------------------------------------------------------------------------------------------
Fair Value of Contracts
- ---------------------------------------------------------------------------------------------------
Mature Within Total
Sources of Fair Value 12 Months Thereafter Fair Value
- ---------------------------------------------------------------------------------------------------
Prices actively quoted $ (1,339) - $ (1,339)
Prices based on models and
other valuation methods - - -
Local published indicies 1,207 (387) 820
- ---------------------------------------------------------------------------------------------------
$ (132) $ (387) $ (519)
- ---------------------------------------------------------------------------------------------------
We measure the commodity risk of our derivative hedging instruments using a
sensitivity analysis. Based on a sensitivity analysis as of September 30, 2004,
a 10% increase in heating oil and natural gas prices would decrease the value of
derivative instruments maturing in 2004 by $1.9 million, while the value of
expected physical deliveries for the remainder of 2004 would be enhanced $2.5
million (net benefit to KeySpan of $0.6 million). A 10% decrease in heating oil
and natural gas prices would enhance the value of derivative instruments
maturing in 2004 by $1.9 million, while the value of expected physical
deliveries for the remainder of 2004 would be decreased $2.5 million (net cost
to KeySpan of $0.6 million).
Based on a sensitivity analysis as of September 30, 2004, a 10% increase in
electricity and fuel prices would have an immaterial impact on the value of
derivative instruments maturing in 2004, while the value of expected physical
power production for the remainder of 2004 would be enhanced $1.2 million (net
benefit to KeySpan of $1.2 million). A 10% decrease in electricity and fuel
prices would have an immaterial impact on the value of derivative instruments
maturing in 2004, while the value of expected physical power production would be
reduced $1.2 million (net cost to KeySpan of $1.2 million).
Firm Gas Sales Derivative Instruments - Regulated Utilities: We use derivative
financial instruments to reduce the cash flow variability associated with the
purchase price for a portion of future natural gas purchases associated with our
Gas Distribution operations. The accounting for these derivative instruments is
subject to SFAS 71 "Accounting for the Effects of Certain Types of Regulation."
Therefore, changes in the fair value of these derivatives have been recorded as
a regulatory asset or regulatory liability on the Consolidated Balance Sheet.
Gains or losses on the settlement of these contracts are initially deferred and
then refunded to or collected from our firm gas sales customers consistent with
regulatory requirements.
74
The following table sets forth selected financial data associated with these
derivative financial instruments that were outstanding at September 30, 2004.
- ------------------------------------------------------------------------------------------------------------------------------------
Type of Year of Volumes Fixed Current Fair Value
Contract Maturity mmcf Floor ($) Ceiling ($) Price ($) Price ($) ($000)
- ------------------------------------------------------------------------------------------------------------------------------------
Options 2004 3,940 5.00 - 6.00 5.00 - 7.00 - 6.80 - 7.64 1,950
2005 9,420 5.00 - 6.00 5.00 - 7.00 - 6.42 - 8.03 7,769
2006 2,480 5.00 - 6.00 5.50 - 6.75 5.82 - 7.07 749
Swaps 2004 16,140 - - 5.90 - 6.21 6.80 - 7.64 20,221
2005 38,230 - - 6.05 - 6.25 6.42 - 8.03 53,632
2006 6,260 - - 6.27 - 6.30 5.82 - 7.07 2,804
- ------------------------------------------------------------------------------------------------------------------------------------
76,470 87,125
- ------------------------------------------------------------------------------------------------------------------------------------
See Note 4 to the Consolidated Financial Statements "Hedging and Derivative
Financial Instruments" for a further description of all our derivative
instruments.
Item 4. Controls and Procedures
KeySpan maintains "disclosure controls and procedures," as such term is defined
under Exchange Act Rule 13a-15(e), that are designed to ensure that information
required to be disclosed by KeySpan in the reports it files or submits under the
Securities Exchange Act of 1934, as amended (the "Exchange Act"), is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's rules and forms, and that such information
is accumulated and communicated to KeySpan's management, including its Chief
Executive Officer and Chief Financial Officer, as appropriate to allow timely
decisions regarding required disclosure.
An evaluation of the effectiveness of KeySpan's disclosure controls and
procedures as of September 30, 2004 was conducted under the supervision and with
the participation of KeySpan's Chief Executive Officer and Chief Financial
Officer. Based on that evaluation, KeySpan's Chief Executive Officer and Chief
Financial Officer have concluded that KeySpan's disclosure controls and
procedures were adequate and designed to ensure that material information
relating to KeySpan and its consolidated subsidiaries would be made known to the
Chief Executive Officer and Chief Financial Officer by others within those
entities, particularly during the periods when periodic reports under the
Exchange Act are being prepared. Furthermore, there has been no change in
KeySpan's internal control over financial reporting, identified in connection
with the evaluation of such control, that occurred during KeySpan's last fiscal
quarter that has materially affected, or is reasonably likely to materially
affect, KeySpan's internal control over financial reporting. Refer to the
Certifications by KeySpan's Chief Executive Officer and Chief Financial Officer
filed as exhibits 31.1 and 31.2 to this report.
75
PART II. OTHER INFORMATION
- ---------------------------
Item 1. Legal Proceedings
See Note 6 to the Consolidated Financial Statements "Financial Guarantees and
Contingencies".
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
31.1* Certification of the Chairman and Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2* Certification of the Executive Vice President and Chief Financial
Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1* Certification of the Chairman and Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
32.2* Certification of the Executive Vice President and Chief Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
- ----------------------
*Filed Herewith
76
KEYSPAN CORPORATION AND SUBSIDIARIES
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on behalf of the undersigned
there unto duly authorized.
KEYSPAN CORPORATION
-------------------
(Registrant)
Date: November 4, 2004 /s/ Gerald Luterman
------------------------
Gerald Luterman
Executive Vice President and
Chief Financial Officer
77