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Securities and Exchange Commission
Washington, DC 20549
FORM 8-K
Current Report
Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Date of Report (Date of earliest event reported) - February 20, 1998
Minnesota Power & Light Company
A Minnesota Corporation
Commission File No. 1-3548
IRS Employer Identification No. 41-0418150
30 West Superior Street
Duluth, Minnesota 55802
Telephone - (218) 722-2641
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Minnesota Power & Light Company
Index
Page
Item 7. Financial Statements and Exhibits
Financial Statements
Signatures 2
Management Discussion and Analysis of Financial Condition
and Results of Operations 3
Reports of Independent Accountants 17
Consolidated Balance Sheet -
December 31, 1997 and 1996 18
Consolidated Statement of Income -
For the year ended December 31, 1997, 1996 and 1995 19
Consolidated Statement of Retained Earnings -
For the year ended December 31, 1997, 1996 and 1995 19
Consolidated Statement of Cash Flows -
For the year ended December 31, 1997, 1996 and 1995 20
Notes to Consolidated Financial Statements 21
Exhibits
23 - Consent of Independent Accountants
27 - Financial Data Schedule
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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Minnesota Power & Light Company
-------------------------------
(Registrant)
February 20, 1998 D. G. Gartzke
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D. G. Gartzke
Senior Vice President - Finance
and Chief Financial Officer
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
[MP LOGO]
MINNESOTA POWER is a broadly diversified service company with operations in four
business segments: (1) Electric Operations, which include electric and gas
services, and coal mining; (2) Water Services, which include water and
wastewater services; (3) Automotive Services, which include a vehicle auction
business, a finance company and an auto transport company; and (4) Investments,
which include a securities portfolio, a 21% equity investment in a financial
guaranty reinsurance and insurance company, and real estate operations.
CONSOLIDATED OVERVIEW
The Company demonstrated strong operating performance in 1997 earning $2.47 per
share of common stock ($2.28 in 1996; $2.16 in 1995). Since 1995, operating
income has more than doubled and net income has increased 20%.
1997 1996 1995
- ---------------------------------------------------------------
Millions
Operating Revenue and Income
Electric Operations $541.9 $529.2 $503.5
Water Services 95.5 85.2 66.1
Automotive Services 255.5 183.9 61.6
Investments 60.9 49.9 43.7
Corporate Charges (0.2) (1.3) (2.0)
------ ------ ------
$953.6 $846.9 $672.9
------ ------ ------
Operating Income
Electric Operations $71.7 $63.6 $67.1
Water Services 12.7 8.1 (2.3)
Automotive Services 28.4 7.7 1.2
Investments 50.8 40.5 29.7
Corporate Charges (33.4) (26.4) (32.7)
------ ------ ------
$130.2 $93.5 $63.0
------ ------ ------
Net Income
Electric Operations $43.1 $39.4 $41.0
Water Services 8.2 5.4 (1.0)
Automotive Services 14.0 3.7 -
Investments 32.1 38.1 41.3
Corporate Charges (19.8) (17.4) (19.4)
------ ------ ------
77.6 69.2 61.9
Discontinued Operations - - 2.8
------ ------ ------
$77.6 $69.2 $64.7
------ ------ ------
- ---------------------------------------------------------------
Earnings Per Share
of Common Stock $2.47 $2.28 $2.16
Average Shares
of Common Stock - Millions 30.6 29.3 28.5
Return on
Average Common Equity 12.1% 11.3% 10.7%
- ---------------------------------------------------------------
All of the Company's business segments reflected ongoing operational
improvements in 1997, stemming from sales growth and continued implementation of
the Company's corporate strategy. Most significant growth came from Automotive
Services where net income increased nearly four times. Expansion projects were a
success as were improvements from operations due to cost controls and increased
sales volume.
The Company measures profitability of its operations through careful budgeting
and monitoring of contributions by business segment to corporate net income.
Corporate Charges represent general corporate expenses, including interest, not
specifically related to any one business segment.
The following summarizes significant events which impacted the Company's
earnings for the past three years. Detailed discussions for each business
segment follow. Abbreviations and acronyms are defined on page 35.
1997. Electric Operations reflected continued strong demand for electricity from
industrial customers and higher profit margins on sales to other power
suppliers. Gains from the sale of certain land and other property were balanced
by start-up costs associated with strategic initiatives and incentive
compensation awards related to total shareholder return performance. Water
Services showed improved operating efficiencies, a full year of higher rates and
a gain from the sale of certain water and wastewater assets. One-time charges
and start-up costs associated with strategic non-regulated initiatives were also
reflected in Water Services. Automotive Services reported increased vehicle
sales and services at auctions, and the addition of 25 new loan production
offices by the financing business. A more conservative allowance for
bad debts offset a gain from
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the sale of excess land. Investments recorded increased sales from real estate
operations. Corporate Charges reflected increased debt service costs to finance
investments in non-regulated operations and various strategic initiatives.
1996. Electric Operations exceeded the record-setting kilowatthour sales of 1995
and established MPEX, the Company's power marketing division. Water Services
reflected increased rates and gains from the strategic sale of water assets.
Automotive Services included a full twelve months of operations. The auction
business added eight auction facilities, while the financing business added 13
loan production offices. Investments included the recognition of tax benefits
and the sale of a joint venture from real estate operations. Corporate Charges
included nine months of distributions with respect to Cumulative Quarterly
Income Preferred Securities issued in March 1996.
1995. Electric Operations reached record-setting kilowatthour sales. Water
Services reflected lower consumption due to abnormally high rainfall and less
customers because of the sale of assets in December 1994. Automotive Services
reported six months of operations and significant start-up costs following the
July 1995 purchase of ADESA. Investments included the recognition of tax
benefits from real estate operations. Corporate Charges included the write-off
of the Company's investment in Reach All Partnership. Discontinued Operations
represented results from the paper and pulp business which was sold in June
1995.
ELECTRIC OPERATIONS
Electric Operations generate, transmit, distribute, and market electricity.
Minnesota Power provides electricity to 122,000 customers in northeastern
Minnesota, while the Company's wholly owned subsidiary, Superior Water, Light
and Power Company, sells electricity to 14,000 customers and natural gas to
11,000 customers, and provides water to 10,000 customers, all in northwestern
Wisconsin. Another wholly owned subsidiary, BNI Coal, owns and operates a
lignite coal mine in North Dakota. Two electric generating cooperatives,
Minnkota Power Cooperative, Inc. and Square Butte, consume virtually all of BNI
Coal's production of lignite coal under contracts extending to 2027.
Electric Operations contributed net income of $43.1 million in 1997 ($39.4
million in 1996; $41.0 million in 1995). Financial performance for 1997
reflected solid operating results, which included higher profit margins from
sales to other power suppliers and gains from the sale of certain land and other
property.
Changes in Electric
Operating Revenue and Income 1997 1996
- --------------------------------------------------------------
(Change from
previous year
in millions)
Retail electric sales $ 1.1 $(2.7)
Sales to other power suppliers (3.0) 22.4
Transmission revenue 2.9 -
Conservation improvement
programs 2.9 -
Fuel clause adjustments 2.9 -
Coal revenue 0.5 1.1
Other 5.4 4.9
----- -----
$12.7 $25.7
- --------------------------------------------------------------
ELECTRIC SALES. Total kWh sales were 12.4 billion in 1997 (13.2 billion in 1996,
the record high; 11.5 billion in 1995). The 6% decline in 1997 was attributable
to restricted market opportunities for MPEX sales. Less power was available for
sale because of higher prices for purchased power, reduction in transmission
capability damaged by severe spring storms in the Midwest, various generating
unit outages at Company and other plants in the Midwest, and less hydro
generation in Canada. MPEX is an expansion of the Company's inter-utility
marketing group which has been a buyer and seller of capacity and energy for
over 25 years in the wholesale power market. The customers of MPEX are other
power suppliers in the Midwest and Canada. MPEX also contracts with its
customers to provide hourly energy scheduling and power trading services.
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The two major industries in Minnesota Power's service territory are taconite
production, and paper and pulp mills. Taconite mining customers accounted for
31% of electric operating revenue in 1997 (32% in 1996; 35% in 1995). Paper and
pulp customers accounted for 12% of electric operating revenue in 1997 (11% in
1996; 12% in 1995). In addition to these industries, sales to otherpower
suppliers accounted for 12% of electric operating revenue in 1997 (13% in 1996;
9% in 1995).
Taconite is an important raw material for the steel industry and is made from
low iron content ore mined in northern Minnesota. Taconite processing plants use
large quantities of electric power to grind the ore and concentrate the iron
particles into taconite pellets. Annual taconite production in Minnesota was 47
million tons in 1997 (46 million tons in 1996; 47 million tons in 1995).
Minnesota Power expects taconite production in 1998 to remain at or near the
1997 level.
While taconite production is expected to continue at annual levels over 40
million tons, the long-term future of this cyclical industry is less certain.
Production may decline gradually some time after the year 2008.
LARGE POWER CUSTOMER CONTRACTS. The Company has electric service contracts with
11 large power industrial customers that require 10 MW or more of power (five
taconite producers, four paper and pulp mills, and two pipeline companies). Each
contract requires payment of a minimum monthly demand charge that covers a
portion of the fixed costs associated with having capacity available to serve
them, including a return on common equity. The demand charge is paid by these
customers even if no electrical energy is taken. An energy charge is also paid
to cover the variable cost of energy actually used. The rates and corresponding
revenue associated with capacity and energy provided under these contracts are
subject to change through the regulatory process governing all retail electric
rates.
Minimum Revenue and Demand
Under Contract as of February 1, 1998
- --------------------------------------------------------------
Minimum Monthly
Annual Revenue Megawatts
1998 $92.1 million 586
1999 $78.3 million 512
2000 $69.2 million 465
2001 $66.5 million 448
2002 $47.3 million 319
- --------------------------------------------------------------
Based on past experience and projected operating levels, the Company believes
revenue from large power customers will be substantially in excess of the
minimum contract amounts.
In addition to the minimum demand provisions, contracts with taconite producers
and pipeline companies require these customers to purchase their entire electric
service requirements from the Company for the duration of the contract. In
addition, six of the large power customers purchase a combined total of 200 MW
of interruptible service pursuant to contractual commitments and an
interruptible rate schedule. Under this schedule and pursuant to contractual
commitments, the Company has the right to serve 100 MW of these customers' needs
through Oct. 31, 2008, and another 100 MW of these customers' needs through
April 30, 2010. The Company has the right of first refusal to serve an
additional 200 MW during these same time periods.
Contract termination dates range from October 1999 to July 2008. Each contract
continues after the contract termination date, unless the required four-year
advance notice of cancellation has been given. These contract termination dates
exclude any interruptible service commitments. Minnesota Power has implemented a
key account management process and anticipates continuing negotiations with its
large industrial and commercial customers to explore contractual options to
lower energy costs. During 1996 and 1997 the Company successfully negotiated
extended contracts with six of its large power customers. Contract extensions
with two more large power customers are pending MPUC approvals.
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[Graphic Material Omitted]
Average Cost of Fuel
For Electric Generation
Cents per Million Btu's
- ------------------------------------------------------------------------
Total West
Electric North
Utility Central Minnesota
Industry Region Power
------------ ------------ --------------
1992 166.6 118.7 118.9
93 166.6 111.9 115.6
94 152.6 100.9 97.0
95 145.2 97.6 99.4
96 151.9 94.6 96.5
97 N/A N/A 99.6
FUEL. The cost of coal is the Company's largest single operating expense in
generating electricity. Coal consumption at the Company's generating stations in
1997 was 4.1 million tons. Minnesota Power currently has three coal supply
agreements in place with Montana suppliers. Two terminate in December 1999 and
the other in December 2000. Under these agreements the Company has the tonnage
flexibility to procure 70% to 100% of its total coal requirements. The Company
uses this flexibility to purchase coal under spot-market agreements when
favorable market conditions exist. The Company is exploring future supply
options and believes that adequate supplies of low-sulfur, sub-bituminous coal
will continue to be available. The Company has contracts with Burlington
Northern Santa Fe Railroad to deliver coal from Montana and Wyoming to the
Company's generating facilities in Minnesota through December 2003.
PURCHASED POWER CONTRACT. Under an agreement extending through 2007 with Square
Butte, Minnesota Power purchases 71% (about 317 MW during the summer months and
322 MW during the winter months) of the output of a mine-mouth generating unit
located near Center, North Dakota. The Square Butte unit is one of two
lignite-fired units at Minnkota Power Cooperative's Milton R. Young Generating
Station.
Square Butte has the option, upon a five year advance notice, to reduce the
Company's share of the unit's output to 49%. Minnesota Power has the option,
though not the obligation, to continue to purchase 49% of the output at
market-based prices after 2007 to the end of the plant's economic life.
Minnesota Power must pay any Square Butte costs and expenses that have not been
paid by Square Butte when due, regardless of whether or not the Company receives
any power from that unit.
COMPETITION. The electric utility industry continues to evolve at both the
wholesale and retail levels. This has resulted in a more competitive market for
electricity generally and particularly in wholesale markets. Retail deregulation
of the industry is being considered at both the Federal and state level, and
affects the way the Company strategically views the future. With electric rates
among the lowest in the U.S. and with long-term wholesale and large power retail
contracts in place, Minnesota Power believes its Electric Operations are well
positioned to address and benefit from competitive pressures.
WHOLESALE. Minnesota Power's MPEX division conducts an active wholesale power
marketing and trading business. On Dec. 15, 1997, Manitoba Hydro and Minnesota
Power jointly announced the signing of a three-year agreement whereby MPEX will
provide Manitoba Hydro with hourly power trading and energy scheduling services
in the U.S. This agreement became effective Jan. 1, 1998. Manitoba Hydro is the
fourth largest electric utility in Canada. More than a third of Manitoba Hydro's
electric sales represent exports of renewable hydroelectricity to the U.S. and
neighboring provinces in Canada. MPEX is reviewing new strategic opportunities
for its wholesale marketing operations in light of the new Open Access
Transmission Rules enacted by FERC in 1996. Wholesale contracts with a number of
municipal customers have been extended and modified.
In 1996 the Company completed functional unbundling of its operations under FERC
Order No. 888, "Open Access Transmission Rules." This order required public
utilities to take transmission service for their own wholesale transactions
under the same terms and conditions on which transmission service is provided to
third parties. Also in 1996, the Company filed its "Code of Conduct" under FERC
Order No. 889, "Open Access Same Time Information System and Standards of
Conduct," which formalized the functional separation of generation from
transmission within the organization.
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The transmission component of Electric Operations is organized for and
conducting business under these new federal regulatory requirements.
RETAIL. In 1995 the MPUC initiated an investigation into structural and
regulatory issues of the electric utility industry. To make certain that
delivery of electric service will be efficient following any restructuring, the
MPUC adopted 15 principles to guide a deliberate and orderly approach to
developing reasonable restructuring alternatives that ensure the fairness of a
competitive market and protect the public interest. In January 1996 the MPUC
established a competition working group in which company representatives have
participated in addressing issues related to wholesale and retail competition.
That group issued a Wholesale Competition Report in October 1996 and a Retail
Competition Report in November 1997. The MPUC is expected to begin identifying
the steps that are necessary to successfully implement restructuring upon
receipt of a legislative mandate.
LEGISLATION. During 1998 Congress is expected to continue to debate proposed
legislation which, if enacted, would promote retail customer choice and a more
competitive electric market. The Company is actively participating in the
dialogue and debate on these issues in various forums, principally to advocate
fairness and parity for all power and energy competitors in deregulated markets
that may be created by new legislation. While Congress is not expected to pass
legislation in 1998, the Company cannot predict the timing or substance of any
future legislation which might ultimately be enacted. However, the Company will
take the necessary steps to maintain its competitive position as both a low-cost
supplier and a long-term supplier to large industrial customers. The Company is
also promoting property tax reform before the Minnesota legislature in order to
eliminate the taxation of personal property that results in an inequitable tax
burden among current and potential competitors in local markets.
Legislative activity is evolving both in Minnesota and Wisconsin. An Electric
Energy Task Force comprised of representatives of both houses of the Minnesota
legislature continues to study a variety of issues related to industry
restructuring. The Wisconsin legislature is pursuing electric utility industry
restructuring, including the possible formation of an independent transmission
system operator within the state. In Minnesota legislation has been introduced,
but the Governor and legislative leadership have indicated that no action to
restructure the industry will be taken in 1998.
CONSERVATION. Minnesota requires electric utilities to spend a minimum of 1.5%
of annual retail electric revenue on conservation improvement programs (CIP)
each year. An annually approved billing adjustment combined with retail base
rates allows the Company to recover both costs of energy-saving programs and
lost margins associated with power saved as a result of such programs. The
Company's largest conservation programs are targeted at taconite and paper
customers to promote their efficient use of energy. CIP also provides
demand-side management grants on a competitive basis to commercial and small
industrial customers, low-cost financing for energy-saving investments, and
promotes energy conservation for residential and commercial customers. SWL&P
also offers electric and gas conservation programs to qualified customers as
approved by the PSCW.
ENVIRONMENTAL. CLEAN AIR ACT. By burning low sulfur coal in units equipped with
pollution control equipment, the Company's power plants presently operate well
below the sulfur dioxide emission limits set for the year 2000 by the federal
Clean Air Act. The Company has spent $4.2 million and will spend an additional
$1.8 million in 1998 on advanced low emission burner technology and associated
control equipment to operate at or below the compliance standards for nitrogen
oxide emissions required by the Clean Air Act. The final stage of this project
is expected to be completed by mid-1998.
KYOTO PROTOCOL. On Dec. 11, 1997, the United Nations Framework Convention on
Climate Change agreed upon a draft international treaty, the Kyoto Protocol,
(Protocol)
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which, if ratified, would call for reductions in greenhouse gas emissions. The
United States' target is to achieve a 7% reduction below 1990 emission levels by
the period 2008-2012. The Protocol must be ratified by the U.S. Senate by March
15, 1999; however, the treaty does not currently satisfy the guidance provided
in a 1997 Senate resolution. The Company currently cannot predict when or if the
Protocol will be ratified nor can it determine the impact such ratification
would have on the Company.
1997 TO 1996 COMPARISON. Operating revenue and income from Electric Operations
were up $12.7 million in 1997. The demand for electricity by all customer
classes continued to be strong in 1997, as did the marketing of sales to other
power suppliers. Revenue from sales to other power suppliers was 4% lower in
1997 because less power was available. Less power was available for sale because
of higher prices for purchased power, reduction in transmission capability
damaged by severe spring storms in the Midwest, various generating unit outages
at Company and other plants in the Midwest, and less hydro generation in Canada.
While total revenue from sales to other power suppliers was lower in 1997,
higher profit margins were realized on these sales. To ensure the preservation
of wilderness lands, in 1997 the Company sold property along the St. Louis River
to the State of Minnesota. The Company also sold rights to microwave frequencies
in accordance with a federal mandate. Pre-tax gains totaling $4.3 million from
these two sales were included in 1997 operating revenue and income. Total
operating expenses from Electric Operations increased $4.6 million in 1997.
Purchased power expenses and depreciation expense both increased $3 million,
while the recent reform of the Minnesota property tax system reduced property
taxes by $2.8 million in 1997. Start-up costs associated with strategic
initiatives and incentive compensation awards related to total shareholder
return performance also contributed to higher operating expenses in 1997.
Interest expense was $1.2 million lower in 1997 as a result of debt refinanced
at lower rates.
1996 TO 1995 COMPARISON. Operating revenue and income from Electric Operations
were $25.7 million higher in 1996 due to a 14% increase in total kWh sales. The
increase in sales was primarily attributed to the Company's marketing of power
to other power suppliers. Extreme winter weather in 1996 compared to the milder
winter in 1995 increased sales to residential and commercial customers, and
reduced sales to taconite producers. While revenue from sales of electricity was
higher in 1996, lower margins were realized because the cooler summer weather in
1996 resulted in lower wholesale pricing. Total electric operating expenses were
$29.2 million higher in 1996. The $13.9 million increase in fuel and purchased
power expenses in 1996 was attributed to the 14% increase in total kWh sales. In
addition, Square Butte, one of Minnesota Power's low priced sources of energy,
produced 23% more energy in 1996 after being down for scheduled maintenance in
1995. Operations expenses included costs associated with the mid-1995 early
retirement offering which was part of the Company's ongoing efforts to control
costs and maintain low electric rates. The cost of the offering was $15 million
and is being amortized over 3 years. Expenses in 1996 included twelve months of
amortization, while 1995 included only five months. Employee and customer
related expenses were also higher in 1996.
OUTLOOK. The contribution from Electric Operations is expected to remain stable
as the industry continues to restructure. Electric Operations intend to seek
additional cost saving alternatives and efficiencies, and expand non-regulated
services to maintain its contribution to net income. MP Enterprises, a wholly
owned subsidiary of the Company, was created in 1996 to facilitate the
development of the non-regulated services of Electric Operations. It provides
the required expertise necessary to offer these services within and outside the
Company's electric service territory. The Company's newest non-regulated
subsidiary, MP Telecom, was established in 1997 to provide high volume fiber
optic and microwave communications to businesses across the Company's service
territory.
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WATER SERVICES
Water Services are comprised of regulated and non-regulated wholly owned
subsidiaries of the Company. REGULATED SUBSIDIARIES. Florida Water, the largest
investor owned water supplier in Florida, provides water to 119,000 customers
and wastewater treatment services to 52,000 customers in Florida. Heater
provides water to 28,000 customers and wastewater treatment services to 2,000
customers in North Carolina and South Carolina. NON-REGULATED SUBSIDIARIES.
Instrumentation Services, Inc. and U.S. Maintenance and Management provide
predictive maintenance services to water utility companies and other industrial
operations in several southern states. Headquartered in Chicago, Illinois,
Americas' Water offers contract management, operations and maintenance services
to governments and industries throughout the Americas.
Water Services contributed net income of $8.2 million in 1997 ($5.4 million in
1996; $(1.0) million in 1995). Financial performance for 1997 reflected improved
operating efficiencies at Florida Water, a full year of rate relief and a gain
from the strategic sale of certain water assets.
[Graphic Material Omitted]
Water Services
Operating Revenue
and Income
Millions
-----------------------
1995 $66.1
96 $85.2
97 $95.5
WATER AND WASTEWATER RATES. 1995 RATE CASE. Florida Water requested an $18.1
million rate increase in June 1995 for all water and wastewater customers of
Florida Water regulated by the FPSC. In October 1996 the FPSC issued its final
order approving an $11.1 million annual increase. In November 1996 Florida Water
filed with the Florida First District Court of Appeals (Court of Appeals) an
appeal of the final order seeking judicial review of issues relating to the
amount of investment in utility facilities recoverable in rates from current
customers. Other parties to the rate case also filed appeals. In June 1997, as
part of the review process, the FPSC allowed Florida Water to resume collecting
approximately $1 million, on an annual basis, in new customer connection fees.
The Company is unable to predict the timing or outcome of the appeals process.
1991 RATE CASE REFUNDS. In 1995 the Court of Appeals reversed a 1993 FPSC order
establishing uniform rates for most of Florida Water's service areas. With
"uniform rates," all customers in a uniform rate area pay the same rates for
water and wastewater services. In response to the Court of Appeals' order, in
August 1996 the FPSC ordered Florida Water to issue refunds to those customers
who paid more since October 1993 under uniform rates than they would have paid
under stand-alone rates. This order did not permit a balancing surcharge to
customers who paid less under uniform rates. Florida Water appealed, and the
Court of Appeals ruled in June 1997 that the FPSC could not order refunds
without balancing surcharges. In response to the Court of Appeals' ruling, the
FPSC issued an order on Jan. 26, 1998, that would not require Florida Water to
refund about $12.5 million, which included interest, to customers who paid more
under uniform rates.
Also on Jan. 26, 1998, the FPSC ordered Florida Water to refund $2.5 million,
the amount paid by customers in the Spring Hill service area from January 1996
through June 1997 under uniform rates which exceeded the amount these customers
would have paid under a modified stand-alone rate structure. No balancing
surcharge was permitted. The FPSC ordered this refund because Spring Hill
customers continued to pay uniform rates after other customers began paying
modified stand-alone rates effective January 1996 pursuant to the FPSC's interim
rate order in Florida Water's 1995 Rate Case. The FPSC did not include Spring
Hill in this interim rate order because Hernando County had assumed jurisdiction
over Spring Hill's rates. In June 1997 Florida Water reached an agreement with
Hernando County to revert to stand-alone rates for Spring Hill customers. The
Company
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intends to appeal the $2.5 million refund. No provision for refund has
been recorded.
COMPETITION. Water Services provide water and wastewater utility services at
regulated rates within exclusive service territories granted by regulators.
1997 TO 1996 COMPARISON. Operating revenue and income from Water Services were
$10.3 million higher in 1997 because of increased rates approved by the FPSC in
1996 for Florida Water customers and a $7.3 million pre-tax gain from the
strategic sale of water and wastewater assets to Orange County, Florida, in
December 1997. These assets served about 4,000 customers. Also in 1997, Heater
acquired LaGrange, a water utility near Fayetteville, North Carolina, for $3.4
million. The acquisition added 5,300 water customers and contributed $0.9
million in revenue. The increase in revenue was partially offset by lower
revenue following the sale of two water systems in South Carolina in 1996.
Together the two strategic sales resulted in pre-tax gains of $1.7 million
during 1996. Sales were up 3% in 1997, despite heavy rainfall and continued
water conservation efforts by customers. Non-regulated water subsidiaries
contributed $1.2 million more to revenue in 1997. Total operating expenses from
Water Services were $5.7 million higher in 1997 primarily due to start-up costs
associated with the Company's non-regulated water subsidiaries. Approximately $2
million of one-time charges relating to the amount of investment in utility
facilities were also included in operating expenses in 1997. These higher
operating expenses were tempered by improved operating efficiencies at Florida
Water. Interest expense decreased $1.5 million in 1997 due to lower interest
rates on refinanced debt.
1996 TO 1995 COMPARISON. Operating revenue and income from Water Services were
$19.1 million higher in 1996. Rate relief and a 9% increase in sales in 1996 are
primarily responsible for the increase. A 2% growth in customers and the return
of more typical weather in Florida both contributed to higher sales in 1996. The
increase in sales was tempered by continued customer conservation efforts.
Florida Water added 17,000 new water and wastewater customers as a result of the
December 1995 purchase of the assets of Orange Osceola Utilities in Florida. As
part of a strategic decision to withdraw from South Carolina, Heater sold the
majority of its assets in that state and recognized $1.7 million in pre-tax
gains during 1996. Non-regulated water subsidiaries contributed $5.3 million to
revenue in 1996. Total operating expenses from Water Services were $8.7 million
higher in 1996 primarily due to the acquisition of Orange Osceola Utilities. The
addition of non-regulated operations also increased operating expenses in 1996.
OUTLOOK. Florida Water and Heater continue to position themselves for further
expansion by selectively acquiring and selling targeted water systems. The
strategic emphasis at Heater is growth and consolidation in North Carolina.
Water Services has been laying the groundwork for future growth in several new
areas of the water business. Non-regulated subsidiaries have initiated marketing
the Company's water expertise outside traditional utility boundaries.
AUTOMOTIVE SERVICES
Automotive Services include wholly owned subsidiaries: ADESA, a vehicle auction
business; AFC, a finance company; and Great Rigs, an auto transport company.
ADESA is the third largest vehicle auction business in the U.S. Headquartered in
Indianapolis, Indiana, ADESA owns and operates 25 vehicle auctions in the U.S.
and Canada through which used cars and other vehicles are purchased and sold by
franchised automobile dealers and licensed used car dealers. Sellers at ADESA's
auctions include domestic and foreign auto manufacturers, car dealers,
automotive fleet/lease companies, banks and finance companies. ADESA's
Professional Auto Remarketing (PAR) division provides customized remarketing
services to various businesses with fleet operations.
AFC provides inventory financing for wholesale and retail automobile dealers who
purchase vehicles from
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ADESA auctions, independent auctions and other auction chains. Headquartered in
Indianapolis, Indiana, AFC has 57 loan production offices. From these offices
car dealers obtain credit to purchase vehicles at any of the over 300 auctions
approved by AFC.
Great Rigs, headquartered in Moody, Alabama, is one of the nation's largest
independent used automobile transport companies. It offers customers pick up and
delivery service through 11 strategically located transportation hubs. Customers
of Great Rigs include ADESA auctions, car dealerships, vehicle manufacturers,
leasing companies, finance companies and other auctions.
The Company acquired 80% of ADESA on July 1, 1995. On Jan. 31, 1996, the Company
provided additional capital in exchange for 3% of ADESA. On Aug. 21, 1996, the
Company acquired the remaining 17% ownership interest of ADESA from the ADESA
management shareholders.
Automotive Services contributed net income of $14.0 million in 1997 ($3.7
million in 1996; $0.0 million for the six months of ownership in 1995).
Financial performance for 1997 reflected increased vehicle sales and services,
improved operating efficiencies at ADESA auctions and growth of the financing
business.
[Graphic Material Omitted]
Number of Vehicles Sold
Thousands
---------------------------------
Minnesota
Power Predecessor
--------- -----------
1995 230 240
96 637
97 769
COMPETITION. Within the automobile auction industry, ADESA's competition
includes independently owned auctions as well as major chains and associations
with auctions in geographic proximity. ADESA competes with other auctions for a
supply of automobiles to be sold on consignment for automobile dealers,
financial institutions and other sellers. ADESA also competes for a supply of
rental repurchase vehicles from automobile manufacturers for auction at factory
sales. The automobile manufacturers often choose between auctions across
multi-state areas in distributing rental repurchase vehicles. ADESA competes for
these sellers of automobiles by attempting to attract a large number of dealers
to purchase vehicles, which ensures competitive prices and supports the volume
of vehicles auctioned. ADESA also competes by providing a full range of services
including reconditioning services which prepare vehicles for auction,
transporting vehicles and the prompt processing of sale transactions. In 1997
ADESA agreed with another U.S. auction company to jointly sell Toyota Motor
Credit Corporation (TMCC) vehicles through a common Internet "Cyberlot." The
Cyberlot provides descriptions and photos of vehicles along with the price
established by TMCC. This gives dealers the opportunity to buy vehicles through
the Internet. Another factor affecting the industry, the impact of which is yet
to be determined, is the entrance of the large used car dealerships called
"superstores" that have emerged in densely populated markets.
AFC is well positioned as a provider of floorplan financing services to the used
vehicle industry. AFC's competition includes other specialty lenders, as well as
banks and other financial institutions. AFC competes with other floorplan
providers and strives to distinguish itself based upon convenience and quality
of service. A key component of AFC's program is conveniently located loan
production offices with personnel available to assist automobile dealers with
their financing needs. As part of AFC's continued effort to focus on providing
other financing services to dealers, in 1997 AFC entered into an agreement with
ACC Consumer Finance Corp. (ACC). Together these two companies will test a
program designed to promote ACC's purchase of installment contracts that finance
the purchase of vehicles floorplanned by AFC.
1997 TO 1996 COMPARISON. Operating revenue and income from Automotive Services
were $71.6 million higher in 1997 primarily due to increased vehicle sales and
ancillary services, such as reconditioning and transportation, at ADESA auction
facilities. ADESA sold 769,000 vehicles in 1997 (637,000 in 1996).
-11-
<PAGE>
Auction facilities added in 1996 contributed to higher vehicle sales in 1997.
Operating revenue from AFC in 1997 reflected the growth of the floorplan
financing business through expansion of existing loan production offices and the
addition of 25 new office locations. The increase in AFC's dealer/customer base
to 10,000 (4,000 in 1996) enabled AFC to finance 300,000 vehicles (140,000 in
1996). Pre-tax gains totaling $5.7 million from the sale of an auction facility
and excess land were also included in 1997 operating revenue and income. Total
operating expenses at Automotive Services were $50.9 million higher in 1997.
Operating expenses associated with the auction facilities reflected the 21%
increase in vehicles sold and increased ancillary services. These operating
expenses were tempered by improved efficiencies and cost controls at auction
facilities. The expansion of AFC's floorplan financing business and a more
conservative allowance for bad debts also contributed to higher operating
expenses in 1997.
1996 TO 1995 COMPARISON. Financial results for Automotive Services reflected a
full year of operations in 1996, while 1995 only included operations as of July
1, 1995, the purchase date of ADESA. Operating revenue and income from
Automotive Services were higher in 1996 because ADESA added eight new auction
facilities during the year. ADESA sold 637,000 vehicles in 1996 compared to
230,000 vehicles during the last six months of 1995 (470,000 vehicles in total
were sold by ADESA in 1995). Increased ancillary services and the expansion of
AFC also contributed to revenue growth in 1996. Total operating expenses at
Automotive Services were higher in 1996 due to the addition of eight auction
facilities which caused ADESA to incur additional financing expenses and
significant start-up costs. Start-up losses associated with two auction
facilities had a negative impact on profitability of Automotive Services through
1996.
For the six months ended Dec. 31, 1995, operating revenue was $61.6 million with
no net income contribution. Financial results in 1995 were adversely impacted by
auction cancellations due to severe weather conditions on the east coast in
December 1995, as well as start-up losses associated with major construction
projects.
OUTLOOK. Auto auction sales for the industry are expected to rise at a rate of
6% to 8% annually. With the increased popularity of leasing and the high cost of
new vehicles, the same vehicles may come to auction more than once. Automotive
Services expects to participate in the industry's growth through selective
acquisitions and expanded services. ADESA and AFC continue to focus on growth in
the volume of vehicles sold and financed, increased ancillary services, and
operating and technological efficiencies. The expansion of the Great Rigs fleet
of automobile carriers to 150 by the end of second quarter 1998 is also expected
to contribute to future growth.
INVESTMENTS
Investments include a securities portfolio, a 21% equity investment in a
financial guaranty reinsurance and insurance company, and an 80% interest in a
Florida real estate company.
Investments contributed net income of $32.1 million in 1997 ($38.1 million in
1996; $41.3 million in 1995). Financial performance for 1997 reflected a
consistent return on the securities portfolio, an increase in earnings from
Capital Re and an increase in real estate sales. Net income was lower in 1997
because tax benefits were recognized in 1996 and 1995 from real estate
operations.
PORTFOLIO AND REINSURANCE. The Company's securities portfolio is managed by
selected outside managers as well as internal managers. The securities portfolio
is intended to provide stable earnings and liquidity, and is available for
investment in existing businesses, acquisitions and other corporate purposes.
The majority of the portfolio consists of stocks of other utility companies that
have investment grade debt securities. Additionally, the Company sells common
stock securities short and enters into short sales of treasury futures contracts
as part of an overall investment portfolio hedge strategy.
-12-
<PAGE>
The Company's investment in the securities portfolio at Dec. 31, 1997, was
approximately $184 million ($155 million at Dec. 31, 1996).
Capital Re is a Delaware holding company engaged in reinsurance and insurance
through its wholly owned subsidiaries. The market value of the Company's $119
million equity investment in Capital Re was $203 million at Dec. 31, 1997 ($152
million at Dec. 31, 1996).
1997 TO 1996 COMPARISON. Operating revenue and income from the securities
portfolio were $1.4 million higher in 1997 because the Company's average
portfolio balance was larger. Income tax expense was $5.7 million higher in 1997
because of increased operating income. In addition, 1996 reflected a one-time
tax benefit for an IRS audit adjustment. Together, the Company's securities
portfolio and its equity investment in Capital Re earned an annualized after-tax
return of 8.6% in 1997 (8.8% in 1996). Income from equity investments included
$14.8 million in 1997 ($11.8 million in 1996) of income from the Company's
investment in Capital Re.
1996 TO 1995 COMPARISON. Operating revenue and income from the securities
portfolio were $3.5 million lower in 1996 due to a smaller average portfolio
balance. In 1995 the Company sold approximately $60 million of securities to
finance the purchase of ADESA. Income tax expense reflected a one-time tax
benefit for an IRS audit adjustment in 1996. Together, the Company's securities
portfolio and its equity investment in Capital Re earned an annualized after-tax
return of 8.8% in 1996 (9.2% in 1995). Income from equity investments included
$11.8 million of income in 1996 ($9.8 million in 1995) from the Company's
investment in Capital Re.
OUTLOOK. The Company's objective is to maintain corporate liquidity between 7%
and 10% of total assets ($150 to $200 million). The Company plans to continue to
concentrate in market-neutral investment strategies designed to provide stable
and acceptable returns without sacrificing needed liquidity. The portfolio is
hedged against market downturns and aimed at an after-tax return between 7% and
9%. While these returns may seem modest compared to broader market indices over
the past three years, the Company believes its hedge strategy is a wise course
in a volatile economic environment. Actual returns will be partially dependent
on general market conditions. Capital Re will continue to be a core component
of the Company's Investments segment.
[Graphic Material Omitted]
Investments
Millions
----------------------------------------------
Portfolio Reinsurance Real Estate
--------- ----------- -----------
1995 $116.1 $92.9 $34.5
96 $153.4 $102.3 $64.7
97 $169.4 $118.8 $66.7
REAL ESTATE OPERATIONS. The Company owns 80% of Lehigh, a real estate company in
Florida. Lehigh owns 2,500 acres of land and approximately 4,000 home sites near
Fort Myers, Florida, 1,000 home sites in Citrus County, Florida, and 2,700 home
sites and 12,000 acres of residential, commercial and industrial land at Palm
Coast, Florida.
TAX BENEFITS. The Company, through Lehigh, acquired the stock of Lehigh
Corporation in a bargain purchase in 1991. The carried-over tax bases of the
underlying assets exceeded the book bases assigned in purchase accounting. The
Internal Revenue Code (IRC) limits the use of tax losses resulting from the
higher tax basis.
SFAS 109, "Accounting for Income Taxes," was adopted on a prospective basis
effective Jan. 1, 1993. Upon adoption, a valuation reserve was established for
the entire amount of the tax benefits attributable to the bases differences and
alternative minimum tax credits because, in management's judgment, realization
of the tax benefits was not "more likely than not." This judgment was based on
the unlikelihood of realizing the tax benefits due to the IRC restrictions in
light of management's existing five year property disposal plan.
In 1995 based on a detailed analysis of projected cash flow, Lehigh implemented
a business strategy which called for Lehigh to dispose of its remaining real
estate assets with a specific
-13-
<PAGE>
view towards maximizing realization of the tax benefits. Accordingly, in 1995
the valuation reserve was reduced by $18.4 million. In 1996 the remaining $8.2
million valuation reserve was reversed as a result of the projected positive
impact the 1996 Palm Coast acquisition would have on Lehigh's taxable income.
1997 TO 1996 COMPARISON. Financial results for real estate operations reflected
twelve months of Palm Coast operations in 1997 compared to less than nine months
in 1996. Operating revenue and income from real estate operations were $9.6
million higher in 1997 primarily due to increased sales from Palm Coast
operations. In 1996 operating revenue and income included $3.7 million from the
sale of Lehigh's joint venture investment in a resort and golf course. Total
operating expenses (excluding minority interest) from real estate operations
were $5.7 million higher in 1997. The increase was attributed to more sales
activity and additional expenses as a result of Palm Coast operations. Income
tax expense in 1996 included the recognition of $8.2 million of tax benefits at
Lehigh. The Company's portion of the tax benefits was $6.6 million in 1996.
1996 TO 1995 COMPARISON. Operating revenue and income from real estate
operations were $9.7 million higher in 1996 due primarily to increased real
estate sales from the Palm Coast operations and $3.7 million from the sale of
Lehigh's joint venture in a resort and golf course. In 1996 Lehigh purchased
properties at Palm Coast, Florida, and expanded its marketing program
nationwide. Total operating expenses (excluding minority interest) from real
estate operations were $1.7 million lower in 1996. The decrease was attributed
to exiting several auxiliary businesses and cost containment efforts. Income tax
expense included the recognition of $8.2 million of tax benefits in 1996 ($18.4
million in 1995). The Company's portion of the tax benefits was $6.6 million in
1996 ($14.7 million in 1995).
OUTLOOK. The real estate strategy is to continue to acquire large residential
community properties at low cost, add value and sell them at current market
prices.
LIQUIDITY AND CAPITAL RESOURCES
Cash flow from operations improved significantly during 1997 due to better
management of working capital throughout the Company and capital expenditure
discipline. Cash flow after funding capital expenditures was $117 million in
1997 ($35 million in 1996). Automotive Services experienced a major turnaround
in cash flow generating $23 million in 1997 ($(34) million in 1996).
Working capital, if and when needed, generally is provided by the sale of
commercial paper. In addition, securities investments can be liquidated to
provide funds for reinvestment in existing businesses or acquisition of new
businesses, and approximately 4 million original issue shares of common stock
are available for issuance through the DRIP. Minnesota Power's $60 million bank
lines of credit provide liquidity for the Company's commercial paper program.
The amount and timing of future sales of the Company's securities will depend
upon market conditions and the specific needs of the Company. The Company may
from time to time sell securities to meet capital requirements, to provide for
the retirement or early redemption of issues of long-term debt and preferred
stock, to reduce short-term debt and for other corporate purposes.
A substantial amount of ADESA's working capital is generated internally from
payments made by vehicle purchasers. However, ADESA uses commercial paper issued
by the Company to meet short-term working capital requirements arising from the
timing of payment obligations to vehicle sellers and the availability of funds
from vehicle purchasers. During the sales process, ADESA does not typically take
title to vehicles.
AFC also uses commercial paper issued by the Company to meet its operational
requirements. AFC offers short-term on-site financing for dealers to purchase
vehicles at auctions in exchange for a security interest in those vehicles. The
financing is provided through the earlier of the date the dealer sells the
vehicle or a general borrowing term of 30-60 days. As a result of AFC's
continued expansion of the financing program for dealers, AFC has
-14-
<PAGE>
sold $124 million of receivables to a third party purchaser as of Dec. 31, 1997
($50 million as of Dec. 31, 1996). Under the terms of a five-year agreement
amended in August 1997, the purchaser agrees to purchase receivables aggregating
$225 million, at any one time outstanding, to the extent that such purchases are
supported by eligible receivables. Proceeds from the sale of the receivables
were used to repay borrowings from the Company and fund vehicle inventory
purchases for AFC's customers.
During 1997 the Company sold $60 million of First Mortgage Bonds, 7% Series due
Feb. 15, 2007, and $20 million of First Mortgage Bonds, 6.68% Series due Nov.
15, 2007. The proceeds were used for the retirement of $60 million in principal
amount of the Company's First Mortgage Bonds, 7 3/8% Series due March 1, 1997,
and $18 million in principal amount First Mortgage Bonds, 6 1/2% Series redeemed
in December. The remaining proceeds were used for general corporate purposes.
In June 1997 Minnesota Power refinanced $10 million of industrial development
revenue bonds and $29 million of pollution control bonds with $39 million of
Variable Rate Demand Revenue Refunding Bonds Series 1997A due June 1, 2020,
Series 1997B and Series 1997C due June 1, 2013, and Series 1997D due Dec. 1,
2007.
In May 1997 MP Water Resources' $30 million 10.44% long-term note payable was
replaced with $28 million of Florida Water's First Mortgage Bonds, 8.01% Series
due May 30, 2017, and $7 million of Heater's First Mortgage Bonds, 7.05% due
June 20, 2022. The remaining proceeds were used for general corporate purposes.
Minnesota Power's electric utility first mortgage bonds and secured pollution
control bonds are currently rated investment grade Baa1 by Moody's Investor
Services and A by Standard and Poor's. The Company's investment rating is
currently Baa1 by Moody's Investor Services and BBB+ by Standard and Poor's. The
disclosure of these securities ratings is not a recommendation to buy, sell or
hold the Company's securities.
In 1997 the Company paid out 83% (89% in 1996; 94% in 1995) of its per-share
earnings in dividends. Over the longer term, Minnesota Power's goal is to reduce
dividend payout to 75%-80% of earnings.
[Graphic Material Omitted]
Capital Expenditures
Millions
------------------------------
Actual Projected
------ ---------
1995 $115
96 $101
97 $72
98 $90
99 $89
2000 $76
1 $66
2 $70
CAPITAL REQUIREMENTS. Consolidated capital expenditures totaled $72 million in
1997 ($101 million in 1996; $115 million in 1995). Expenditures in 1997 included
$35 million for Electric Operations, $22 million for Water Services, $11 million
for Automotive Services and $4 million for corporate purposes. Internally
generated funds were the primary source for funding capital expenditures.
Capital expenditures are expected to be $90 million in 1998 and total about $301
million for 1999 through 2002. The 1998 amount includes $45 million for electric
system component replacement and upgrades, telecommunication fiber, and coal
handling equipment, $24 million to meet environmental standards, expand water
and wastewater treatment facilities to accommodate customer growth, and for
water conservation initiatives and $21 million for on-going improvements at
existing vehicle auction facilities and associated computer systems. The Company
expects to use internally generated funds and original issue equity securities
to fund these capital expenditures.
YEAR 2000. The Year 2000 issue relates to computer systems that recognize the
year using the last two digits. Unless corrected, the year 2000 may be
interpreted as 1900 causing errors or shutdowns in computer systems. In recent
years the Company has replaced its major systems with systems considered to be
Year 2000 compliant. A project team is coordinating a comprehensive
-15-
<PAGE>
review of all the Company's remaining software systems and micro-based systems
for Year 2000 compliance. The review process includes key outside entities with
which the Company interacts. The Company anticipates having all systems reviewed
and an estimate of the Company's cost to meet Year 2000 compliance by mid-1998.
A significant proportion of these costs are not likely to be incremental costs
to the Company, but rather will represent the redeployment of existing
information technology resources.
The Year 2000 issue may impact other entities with which the Company transacts
business. The Company cannot estimate or predict the potential adverse
consequences, if any, that could result from such entities' failure to address
this issue.
SAFEHARBOR STATEMENT. In connection with the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995 (Reform Act), the Company is
hereby filing cautionary statements identifying important factors that could
cause the Company's actual results to differ materially from those projected in
forward-looking statements (as such term is defined in the Reform Act) made by
or on behalf of the Company in this Annual Report, in presentations, in response
to questions or otherwise. Any statements that express, or involve discussions
as to expectations, beliefs, plans, objectives, assumptions or future events or
performance (often, but not always, through the use of words or phrases such as
"anticipates", "estimates", "expects", "intends", "plans", "predicts",
"projects", "will likely result", "will continue", and similar expressions) are
not statements of historical facts and may be forward-looking.
Forward-looking statements involve estimates, assumptions, and uncertainties and
are qualified in their entirety by reference to, and are accompanied by, the
following important factors, which are difficult to predict, contain
uncertainties, are beyond the control of the Company and may cause actual
results to differ materially from those contained in forward-looking statements:
(i) prevailing governmental policies and regulatory actions, including those of
the FERC, the MPUC, the FPSC, the NCUC, and the PSCW, with respect to allowed
rates of return, industry and rate structure, acquisition and disposal of assets
and facilities, operation, and construction of plant facilities, recovery of
purchased power, and present or prospective wholesale and retail competition
(including but not limited to retail wheeling and transmission costs); (ii)
economic and geographic factors including political and economic risks; (iii)
changes in and compliance with environmental and safety laws and policies; (iv)
weather conditions; (v) population growth rates and demographic patterns; (vi)
competition for retail and wholesale customers; (vii) pricing and transportation
of commodities; (viii) market demand, including structural market changes; (ix)
changes in tax rates or policies or in rates of inflation; (x) changes in
project costs; (xi) unanticipated changes in operating expenses and capital
expenditures; (xii) capital market conditions; (xiii) competition for new energy
development opportunities; and (xiv) legal and administrative proceedings
(whether civil or criminal) and settlements that influence the business and
profitability of the Company.
Any forward-looking statement speaks only as of the date on which such statement
is made, and the Company undertakes no obligation to update any forward-looking
statement to reflect events or circumstances after the date on which such
statement is made or to reflect the occurrence of unanticipated events. New
factors emerge from time to time and it is not possible for management to
predict all of such factors, nor can it assess the impact of each such factor on
the business or the extent to which any factor, or combination of factors, may
cause results to differ materially from those contained in any forward-looking
statement.
-16-
<PAGE>
REPORTS [LOGO]
INDEPENDENT ACCOUNTANTS
To the Shareholders and
Board of Directors of Minnesota Power
In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of income, of retained earnings and of cash flows
present fairly, in all material respects, the financial position of Minnesota
Power and its subsidiaries at December 31, 1997 and 1996, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 1997, in conformity with generally accepted accounting
principles. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with generally accepted auditing standards which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for the opinion expressed
above.
Price Waterhouse LLP
Minneapolis, Minnesota
January 26, 1998
MANAGEMENT
The consolidated financial statements and other financial information were
prepared by management, which is responsible for their integrity and
objectivity. The financial statements have been prepared in conformity with
generally accepted accounting principles and necessarily include some amounts
that are based on informed judgments and best estimates and assumptions of
management.
To meet its responsibilities with respect to financial information, management
maintains and enforces a system of internal accounting controls designed to
provide assurance, on a cost effective basis, that transactions are carried out
in accordance with management's authorizations and that assets are safeguarded
against loss from unauthorized use or disposition. The system includes an
organizational structure which provides an appropriate segregation of
responsibilities, careful selection and training of personnel, written policies
and procedures, and periodic reviews by the internal audit department. In
addition, the Company has a personnel policy which requires all employees to
maintain a high standard of ethical conduct. Management believes the system is
effective and provides reasonable assurance that all transactions are properly
recorded and have been executed in accordance with management's authorization.
Management modifies and improves its system of internal accounting controls in
response to changes in business conditions. The Company's internal audit staff
is charged with the responsibility for determining compliance with Company
procedures.
Four directors of the Company, not members of management, serve as the Audit
Committee. The Board of Directors, through its Audit Committee, oversees
management's responsibilities for financial reporting. The Audit Committee meets
regularly with management, the internal auditors and the independent accountants
to discuss auditing and financial matters and to assure that each is carrying
out its responsibilities. The internal auditors and the independent accountants
have full and free access to the Audit Committee without management present.
Price Waterhouse LLP, independent accountants, are engaged to express an opinion
on the financial statements. Their audit is conducted in accordance with
generally accepted auditing standards and includes a review of internal controls
and tests of transactions to the extent necessary to allow them to report on the
fairness of the operating results and financial condition of the Company.
Edwin L. Russell
Edwin L. Russell
Chairman, President and Chief Executive Officer
David G. Gartzke
David G. Gartzke
Chief Financial Officer
-17-
<PAGE>
CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
MINNESOTA POWER CONSOLIDATED BALANCE SHEET
<CAPTION>
December 31 1997 1996
- -----------------------------------------------------------------------------------------------------------------------
Millions
<S> <C> <C>
Assets
Plant and Investments
Electric operations $ 783.5 $ 796.0
Water services 322.2 323.9
Automotive services 167.1 167.3
Investments 252.9 236.5
-------- --------
Total plant and investments 1,525.7 1,523.7
-------- --------
Current Assets
Cash and cash equivalents 41.8 40.1
Trading securities 123.5 86.8
Accounts receivable (less reserve of $12.6 and $6.6) 158.5 164.8
Fuel, material and supplies 25.0 23.2
Prepayments and other 19.9 17.2
-------- --------
Total current assets 368.7 332.1
-------- --------
Other Assets
Goodwill 158.9 167.0
Deferred regulatory charges 64.4 83.5
Other 54.6 39.7
-------- --------
Total other assets 277.9 290.2
-------- --------
Total Assets $2,172.3 $2,146.0
- -----------------------------------------------------------------------------------------------------------------------
Capitalization and Liabilities
Capitalization
Common stock, without par value, 65.0 shares authorized;
33.6 and 32.8 shares outstanding $ 416.0 $ 394.2
Unearned ESOP shares (65.9) (69.1)
Net unrealized gain on securities investments 5.5 2.7
Cumulative foreign translation adjustment (0.8) -
Retained earnings 296.1 283.0
-------- --------
Total common stock equity 650.9 610.8
Cumulative preferred stock 11.5 11.5
Redeemable serial preferred stock 20.0 20.0
Company obligated mandatorily redeemable preferred securities of subsidiary
MP&L Capital I which holds solely Company Junior
Subordinated Debentures 75.0 75.0
Long-term debt 685.4 694.4
-------- --------
Total capitalization 1,442.8 1,411.7
-------- --------
Current Liabilities
Accounts payable 78.7 72.8
Accrued taxes, interest and dividends 67.3 63.7
Notes payable and long-term debt due within one year 133.8 162.9
Other 45.3 37.6
-------- --------
Total current liabilities 325.1 337.0
-------- --------
Other Liabilities
Accumulated deferred income taxes 151.3 148.9
Contributions in aid of construction 102.6 98.4
Deferred regulatory credits 60.7 64.4
Other 89.8 85.6
-------- --------
Total liabilities 404.4 397.3
-------- --------
Commitments and Contingencies
-------- --------
Total Capitalization and Liabilities $2,172.3 $2,146.0
- -----------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of these statements.
</TABLE>
-18-
<PAGE>
<TABLE>
MINNESOTA POWER CONSOLIDATED STATEMENT OF INCOME
<CAPTION>
For the Year Ended December 31 1997 1996 1995
- ----------------------------------------------------------------------------------------------------------------------------------
Millions except per share amounts
<S> <C> <C> <C>
Operating Revenue and Income
Electric operations $541.9 $529.2 $503.5
Water services 95.5 85.2 66.1
Automotive services 255.5 183.9 61.6
Investments 60.7 48.6 41.7
------ ------ ------
Total operating revenue and income 953.6 846.9 672.9
------ ------ ------
Operating Expenses
Fuel and purchased power 194.1 190.9 177.0
Operations 579.9 512.2 389.1
Interest expense 64.2 62.1 48.0
------ ------ ------
Total operating expenses 838.2 765.2 614.1
------ ------ ------
Income from Equity Investments 14.8 11.8 4.2
------ ------ ------
Operating Income 130.2 93.5 63.0
Distributions on Redeemable
Preferred Securities of Subsidiary 6.0 4.7 -
Income Tax Expense 46.6 19.6 1.1
------ ------ ------
Income from Continuing Operations 77.6 69.2 61.9
Income from Discontinued Operations - - 2.8
------ ------ ------
Net Income 77.6 69.2 64.7
Dividends on Preferred Stock 2.0 2.4 3.2
------ ------ ------
Earnings Available for Common Stock $ 75.6 $ 66.8 $ 61.5
------ ------ ------
Average Shares of Common Stock 30.6 29.3 28.5
Basic and Diluted Earnings Per Share
of Common Stock
Continuing operations $2.47 $2.28 $2.06
Discontinued operations - - .10
------ ------ ------
Total $2.47 $2.28 $2.16
------ ------ ------
Dividends Per Share of Common Stock $2.04 $2.04 $2.04
- ----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
CONSOLIDATED STATEMENT OF RETAINED EARNINGS
<CAPTION>
For the Year Ended December 31 1997 1996 1995
- ----------------------------------------------------------------------------------------------------------------------------------
Millions
<S> <C> <C> <C>
Balance at Beginning of Year $283.0 $276.2 $272.6
Net income 77.6 69.2 64.7
Redemption of preferred stock - (0.4) -
------ ------ ------
Total 360.6 345.0 337.3
------ ------ ------
Dividends Declared
Preferred stock 2.0 2.4 3.2
Common stock 62.5 59.6 57.9
------ ------ ------
Total 64.5 62.0 61.1
------ ------ ------
Balance at End of Year $296.1 $283.0 $276.2
- ----------------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of these statements.
</TABLE>
-19-
<PAGE>
<TABLE>
MINNESOTA POWER CONSOLIDATED STATEMENT OF CASH FLOWS
<CAPTION>
For the Year Ended December 31 1997 1996 1995
- -----------------------------------------------------------------------------------------------------------------------------------
Millions
<S> <C> <C> <C>
Operating Activities
Net income $ 77.6 $ 69.2 $ 64.7
Income from equity investments --
net of dividends received (13.9) (11.0) (10.7)
Depreciation and amortization 70.8 65.1 59.5
Deferred income taxes 2.0 (11.8) (26.9)
Pre-tax (gain) loss on sale of plant (14.0) (1.6) 1.8
Changes in operating assets and liabilities net of the effects
of discontinued operations and subsidiary acquisitions
Trading securities (36.7) (46.8) 34.0
Notes and accounts receivable 7.9 (17.5) (13.0)
Fuel, material and supplies (1.8) 3.2 (3.2)
Accounts payable 5.4 (2.8) (9.8)
Other current assets and liabilities 8.8 14.8 15.9
Other -- net 11.2 16.2 0.9
------ ------ ------
Cash from operating activities 117.3 77.0 113.2
------ ------ ------
Investing Activities
Proceeds from sale of investments in securities 47.7 43.1 103.2
Proceeds from sale of discontinued operations --
net of cash sold - - 107.6
Proceeds from sale of plant 19.4 8.8 -
Additions to investments (42.5) (76.7) (50.3)
Additions to plant (53.3) (94.1) (117.7)
Acquisition of subsidiaries -- net of cash acquired (2.4) (66.9) (129.6)
Changes to other assets -- net (1.4) (0.9) (1.0)
------ ------ ------
Cash for investing activities (32.5) (186.7) (87.8)
------ ------ ------
Financing Activities
Issuance of long-term debt 176.7 205.5 28.1
Issuance of preferred securities of subsidiary - 72.3 -
Issuance of common stock 19.7 19.0 6.4
Changes in notes payable -- net (27.2) 56.3 16.7
Reductions of long-term debt (187.8) (155.3) (10.9)
Redemption of preferred stock - (17.6) -
Dividends on preferred and common stock (64.5) (62.0) (61.1)
------ ------ ------
Cash from (for) financing activities (83.1) 118.2 (20.8)
------ ------ ------
Change in Cash and Cash Equivalents 1.7 8.5 4.6
Cash and Cash Equivalents at Beginning of Period 40.1 31.6 27.0
------ ------ ------
Cash and Cash Equivalents at End of Period $ 41.8 $ 40.1 $ 31.6
------ ------ ------
Supplemental Cash Flow Information
Cash paid during the period for
Interest (net of capitalized) $ 66.2 $ 54.4 $ 48.9
Income taxes $ 31.3 $ 25.5 $ 25.0
- -----------------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of these statements.
</TABLE>
-20-
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1
BUSINESS SEGMENTS
Millions
<TABLE>
<CAPTION>
Investments
-------------------
Electric Water Automotive Portfolio & Real Corporate
For the Year Ended December 31 Consolidated Operations Services Services<F1> Reinsurance Estate Charges
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
1997
Operating revenue and income $ 953.6 $541.9 $ 95.5 $255.5 $ 22.1 $38.8 $ (0.2)
Operation and other expense 703.2 403.7 60.6 203.2 2.1 21.9<F2> 11.7
Depreciation and amortization expense 70.8 45.2 11.2 14.0 - 0.1 0.3
Interest expense 64.2 21.3 11.0 9.9 - 0.8 21.2
Income from equity investments 14.8 - - - 14.8 - -
-------- ------ ------ ------ ------ ----- ------
Operating income (loss) 130.2 71.7 12.7 28.4 34.8 16.0 (33.4)
Distributions on redeemable
preferred securities of subsidiary 6.0 1.6 - - - - 4.4
Income tax expense (benefit) 46.6 27.0 4.5 14.4 12.1 6.6 (18.0)
-------- ------ ------ ------ ------ ----- ------
Net income (loss) $ 77.6 $ 43.1 $ 8.2 $ 14.0 $ 22.7 $ 9.4 $(19.8)
-------- ------ ------ ------ ------ ----- ------
Total assets $2,172.3 $973.9 $384.7 $458.1 $288.2 $66.7 $ 0.7
Accumulated depreciation $ 697.5 $562.1 $122.9 $ 12.5 - - -
Accumulated amortization $ 15.7 - - $ 14.4 - $ 1.3 -
Construction work in progress $ 26.2 $ 11.2 $ 9.6 $ 5.4 - - -
- -------------------------------------------------------------------------------------------------------------------------------
1996
Operating revenue and income $ 846.9 $529.2 $ 85.2 $183.9 $ 20.7 $29.2 $ (1.3)
Operation and other expense 638.0 400.9 53.6 152.8 2.7 17.1<F2> 10.9
Depreciation and amortization expense 65.1 42.2 11.0 11.7 - 0.2 -
Interest expense 62.1 22.5 12.5 11.7 - 1.2 14.2
Income from equity investments 11.8 - - - 11.8 - -
-------- ------ ------ ------ ------ ----- ------
Operating income (loss) 93.5 63.6 8.1 7.7 29.8 10.7 (26.4)
Distributions on redeemable
preferred securities of subsidiary 4.7 1.3 - - - - 3.4
Income tax expense (benefit) 19.6 22.9 2.7 4.0 6.4 (4.0)<F3> (12.4)
-------- ------ ------ ------ ------ ----- ------
Net income (loss) $ 69.2 $ 39.4 $ 5.4 $ 3.7 $ 23.4 $14.7 $(17.4)
-------- ------ ------ ------ ------ ----- ------
Total assets $2,146.0 $995.8 $371.2 $456.8 $255.7 $64.7 $ 1.8
Accumulated depreciation $ 653.8 $533.5 $113.8 $ 6.5 - - -
Accumulated amortization $ 8.6 - - $ 7.6 - $ 1.0 -
Construction work in progress $ 22.7 $ 4.0 $ 7.1 $ 11.6 - - -
- -------------------------------------------------------------------------------------------------------------------------------
1995
Operating revenue and income $ 672.9 $503.5 $ 66.1 $ 61.6 $ 24.2 $19.5 $ (2.0)
Operation and other expense 508.8 373.7 46.0 55.3 3.2 20.3<F2> 10.3
Depreciation and amortization expense 57.3 40.3 12.3 4.4 - 0.3 -
Interest expense 48.0 22.4 10.1 0.7 - - 14.8
Income (loss) from equity investments 4.2 - - - 9.8 - (5.6)<F4>
-------- ------ ------ ------ ------ ----- ------
Operating income (loss) 63.0 67.1 (2.3) 1.2 30.8 (1.1) (32.7)
Income tax expense (benefit) 1.1 26.1 (1.3) 1.2 5.8 (17.4)<F3> (13.3)
-------- ------ ------ ------ ------ ----- ------
Income (loss) from continuing operations 61.9 $ 41.0 $ (1.0) $ - $ 25.0 $16.3 $(19.4)
------ ------ ------ ------ ----- ------
Income from discontinued operations 2.8
--------
Net income $ 64.7
--------
Total assets $1,947.6 $992.6 $355.2 $355.8 $209.0 $34.5 $ 0.5
Accumulated depreciation $ 619.3 $508.5 $108.8 $ 2.0 - - -
Accumulated amortization $ 3.0 - - $ 2.3 - $ 0.7 -
Construction work in progress $ 56.0 $ 5.7 $ 12.0 $ 38.3 - - -
- -------------------------------------------------------------------------------------------------------------------------------
<FN>
<F1> Purchased July 1, 1995.
<F2> Includes $2.3 million of minority interest in 1997 ($3.7 million in 1996; $4.1 million in 1995).
<F3> Includes $8.2 million of tax benefits in 1996 ($18.4million in 1995). See Note 15.
<F4> Includes a $6.4 million pre-tax provision from exiting the equipment manufacturing business.
- -------------------------------------------------------------------------------------------------------------------------------
</FN>
</TABLE>
-21-
<PAGE>
2
OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
FINANCIAL STATEMENT PREPARATION. Minnesota Power prepares its financial
statements in conformity with generally accepted accounting principles. These
principles require management to make informed judgments and best estimates and
assumptions that (1) affect the reported amounts of assets and liabilities, (2)
disclose contingent assets and liabilities at the date of the financial
statements, and (3) report amounts of revenue and expenses during the reporting
period. Actual results could differ from those estimates. Abbreviations and
acronyms are defined on page 35.
PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the
accounts of the Company and all of its majority owned subsidiary companies. All
material intercompany balances and transactions have been eliminated in
consolidation. Information for prior periods has been reclassified to present
comparable information for all periods.
NATURE OF OPERATIONS AND REVENUE RECOGNITION. Minnesota Power is a
broadly diversified service company that has operations in four principal
business segments. Corporate charges consist of expenses incurred by the
Company's corporate headquarters and interest and preferred stock expense not
specifically identifiable to a business segment. Management's policy is to not
allocate these expenses to business segments.
ELECTRIC OPERATIONS. Electric Operations generate, transmit, distribute and
market electricity. Electric service is provided to 136,000 customers in
northeastern Minnesota and northwestern Wisconsin. Large power customers, which
include five taconite producers, four paper and pulp mills and two pipeline
companies, purchase under contracts, which extend from October 1999 through July
2008, about half of the electricity the Company sells. BNI Coal, a wholly owned
subsidiary, mines and sells lignite coal to two North Dakota mine-mouth
generating units, one of which is Square Butte. Square Butte supplies Minnesota
Power with 71% of its output under a long-term contract. (See Note 5.)
Electric rates are under the jurisdiction of various state and federal
regulatory authorities. Billings are rendered on a cycle basis. Revenue is
accrued for service provided but not billed. Electric rates include adjustment
clauses which bill or credit customers for fuel and purchased energy costs above
or below the base levels in rate schedules and bill retail customers for the
recovery of CIP expenditures not collected in base rates.
During 1997 revenue derived from one major customer was $56.5 million ($57.1
million in 1996; $60.4 million in 1995). Revenue derived from another major
customer was $42.7 million in 1997 ($41.2 million in 1996; $44.9 million in
1995).
WATER SERVICES. Water Services include several wholly owned subsidiaries of the
Company. Florida Water is the largest investor owned supplier of water and
wastewater utility services in Florida. Heater provides water and wastewater
services primarily in North Carolina. In total, 147,000 water and 54,000
wastewater treatment customers are served. Water and wastewater rates are under
the jurisdiction of various state and county regulatory authorities. Bills are
rendered on a cycle basis. Revenue is accrued for services provided but not
billed. Instrumentation Services, Inc. and U.S. Maintenance and Management
provide predictive maintenance services to water utility companies and other
industrial operations in several southern states. Americas' Water offers
contract management, operations and maintenance services to governments and
industries throughout the Americas.
AUTOMOTIVE SERVICES. Automotive Services include wholly owned subsidiaries:
ADESA, a vehicle auction business; AFC, a finance company; and Great Rigs, an
auto transport company. ADESA is the third largest vehicle auction business in
the U.S. ADESA owns and operates 25 vehicle auctions in the U.S. and Canada
through which used cars and other vehicles are purchased and sold by franchised
automobile dealers and licensed used car dealers. Sellers at ADESA's auctions
include domestic and foreign auto manufacturers, car dealers, automotive
fleet/lease companies, banks and finance companies. AFC provides inventory
financing for wholesale and retail automobile dealers who purchase vehicles from
ADESA auctions, independent auctions and other auction chains. AFC has 57 loan
production offices. From these offices car dealers obtain credit to purchase
vehicles at any of the over 300 auctions approved by AFC. Great Rigs is one of
the nation's largest independent used automobile transport companies. It offers
customers
-22-
<PAGE>
pick up and delivery service through 11 strategically located
transportation hubs. Revenue is recognized when services are performed.
INVESTMENTS. The Company's securities portfolio is intended to provide stable
earnings and liquidity, and is available for reinvestment in existing
businesses, acquisitions and other corporate purposes. The Company has a 21%
ownership in Capital Re, a financial guaranty reinsurance and insurance
company, accounted for using the equity method. The Company also has an 80%
ownership in Lehigh, a Florida real estate business. Real estate revenue is
recognized on the accrual basis.
PLANT DEPRECIATION. Plant is recorded at original cost, and is reported on the
balance sheet net of accumulated depreciation. Expenditures for additions and
significant replacements and improvements are capitalized; maintenance and
repair costs are expensed as incurred. When utility plant is retired or
otherwise disposed of, the cost less net proceeds is normally charged to
accumulated depreciation and no gain or loss is recognized. Contributions in aid
of construction relate to water utility assets, and are amortized over the
estimated life of the associated asset. This amortization reduces depreciation
expense.
Depreciation is computed using the estimated useful lives of the various classes
of plant. In 1997 average depreciation rates for the electric, water and
automotive segments were 3.4%, 2.7% and 4.1%, respectively (3.2%, 2.6% and 3.5%,
respectively in 1996; 3.1%, 2.9% and 4.7%, respectively in 1995).
FUEL, MATERIAL AND SUPPLIES. Fuel, material and supplies are stated at the
lower of cost or market. Cost is determined by the average cost method.
GOODWILL. Goodwill represents the excess of cost over net assets of businesses
acquired and is amortized on a straight-line basis over a 40 year period.
DEFERRED REGULATORY CHARGES AND CREDITS. The Company's utility operations are
subject to the provisions of SFAS 71, "Accounting for the Effects of Certain
Types of Regulation." The Company capitalizes as deferred regulatory charges
incurred costs which are probable of recovery in future utility rates. Deferred
regulatory credits represent amounts expected to be credited to customers in
rates. (See Note 4.)
UNAMORTIZED EXPENSE, DISCOUNT AND PREMIUM ON DEBT. Expense, discount and premium
on debt are deferred and amortized over the lives of the related issues.
CASH AND CASH EQUIVALENTS. The Company considers all investments purchased with
maturities of three months or less to be cash equivalents.
FOREIGN CURRENCY TRANSLATION. Results of operations for Automotive Services'
Canadian subsidiaries are translated into U.S. dollars using the average
exchange rates during the period. Assets and liabilities are translated into
U.S. dollars using the exchange rate on the balance sheet date, except for
intangibles and fixed assets, which are translated at historical rates.
3
ACQUISITIONS AND DIVESTITURES
SALE OF WATER PLANT ASSETS. On Dec. 30, 1997, Florida Water sold water and
wastewater assets to Orange County in Florida for $13.1 million. The facilities
served about 4,000 customers. The transaction resulted in a $4.7 million
after-tax gain which is included in the Company's 1997 earnings.
In March 1996 Heater of Seabrook, Inc., a wholly owned subsidiary of Heater,
sold all of its water and wastewater utility assets to the Town of Seabrook
Island, South Carolina for $5.9 million. This sale was negotiated in
anticipation of an eminent domain action by the Town of Seabrook Island, South
Carolina. In December 1996 Heater sold its Columbia, South Carolina area water
systems to South Carolina Water and Sewer, L.L.C. The Seabrook and Columbia
systems served a total of 6,500 customers. The transactions resulted in a $1
million after-tax gain which was included in the Company's 1996 earnings.
-23-
<PAGE>
ACQUISITION OF LAGRANGE. In 1997 the NCUC approved the transfer of LaGrange
Waterworks Corporation, a water utility near Fayetteville, North Carolina, to
Heater. The Company exchanged 96,000 shares of common stock, with a market value
of approximately $3.4 million, for the outstanding shares of LaGrange and
accounted for the transaction as a pooling of interest. The acquisition added
5,300 water customers. Financial results prior to the acquisition were not
restated due to immateriality.
ACQUISITION OF PALM COAST. In April 1996 Palm Coast Holdings, Inc., a wholly
owned subsidiary of Lehigh Acquisition Corporation, acquired real estate assets
(Palm Coast) from ITT Community Development Corp. and other affiliates of ITT
Industries, Inc. (ITT) for $34 million. These assets included developed
residential lots, a real estate contract receivables portfolio and approximately
13,000 acres of commercial and other land. Palm Coast is a planned community
located between St. Augustine and Daytona Beach, Florida.
ITT's wholly owned subsidiary, Palm Coast Utility Corporation (PCUC), has
granted an option to the Company to acquire PCUC's water and wastewater utility
assets in Palm Coast. PCUC provides services to approximately 12,000 customers
in Flagler County, Florida. The option expires during 1998. If the option is
exercised, closing of the transaction will be subject to various regulatory
approvals.
ACQUISITION OF ISI. In April 1996 MP Water Resources acquired all the
outstanding common stock of Instrumentation Services, Inc., a predictive
maintenance service business, in exchange for 96,526 shares of Minnesota Power
common stock. The acquisition was accounted for as a pooling of interest.
Financial results prior to the acquisition were not restated due to
immateriality.
ACQUISITION OF ORANGE OSCEOLA. In December 1995 Florida Water acquired the
operating assets of Orange Osceola Utilities for approximately $13 million. The
acquisition added over 17,000 water customers.
ACQUISITION OF ADESA. The Company acquired 80% of ADESA on July 1, 1995,
increased its ownership interest to 83% in January 1996 and acquired the
remaining 17% interest in August 1996. The total purchase price was $227
million. The step acquisitions were accounted for by the purchase method.
Accordingly, ADESA earnings have been included in the Company's consolidated
financial statements based on the ownership interest as of the date of each
acquisition. Acquired goodwill and other intangible assets are being amortized
using the straight line method. Pro forma disclosures for the acquisition are
not presented as the impact on consolidated 1996 and 1995 operating results is
immaterial.
In September 1996 Minnesota Power exchanged 473,006 shares of its common stock
for all the outstanding common stock of Alamo Auto Auction, Inc. and Alamo Auto
Auction Houston, Inc. These acquisitions were accounted for as pooling of
interests. Financial results prior to the acquisitions were not restated due to
immateriality.
DISCONTINUED OPERATIONS. On June 30, 1995, Minnesota Power sold its interest in
the paper and pulp business to Consolidated Papers, Inc. (CPI) for $118 million
in cash, plus CPI's assumption of certain debt and lease obligations. The
financial results of the paper and pulp business, including the loss on
disposition, were accounted for as discontinued operations.
Discontinued Operations
Year Ended December 31 1995
- ---------------------------------------------------------------
Millions
Operating revenue and income $44.3
Income from equity investments $7.5
Income from operations $7.5
Income tax expense 3.2
----
4.3
----
Loss on disposal (1.8)
Income tax benefit 0.3
----
(1.5)
----
Income from discontinued operations $2.8
- ---------------------------------------------------------------
EXIT FROM EQUIPMENT MANUFACTURING BUSINESS. In June 1995 Reach All Partnership
ceased operations and sold its operating assets. The pre-tax loss from Reach All
Partnership was $6.4 million in 1995.
-24-
<PAGE>
4
REGULATORY MATTERS
The Company files for periodic rate revisions with the Minnesota Public
Utilities Commission (MPUC), the Federal Energy Regulatory Commission (FERC),
the Florida Public Service Commission (FPSC) and other state and county
regulatory authorities. The MPUC had regulatory authority over approximately 68%
in 1997 (69% in 1996; 73% in 1995) of the Company's total electric operating
revenue. Interim rates in Minnesota and Florida are placed into effect, subject
to refund with interest, pending a final decision by the appropriate commission.
WATER AND WASTEWATER RATES. 1995 RATE CASE. Florida Water requested an $18.1
million rate increase in June 1995 for all water and wastewater customers of
Florida Water regulated by the FPSC. In October 1996 the FPSC issued its final
order approving an $11.1 million annual increase. In November 1996 Florida Water
filed with the Florida First District Court of Appeals (Court of Appeals) an
appeal of the final order seeking judicial review of issues relating to the
amount of investment in utility facilities recoverable in rates from current
customers. Other parties to the rate case also filed appeals. In June 1997, as
part of the review process, the FPSC allowed Florida Water to resume collecting
approximately $1 million, on an annual basis, in new customer connection fees.
The Company is unable to predict the timing or outcome of the appeals process.
1991 RATE CASE REFUNDS. In 1995 the Court of Appeals reversed a 1993 FPSC order
establishing uniform rates for most of Florida Water's service areas. With
"uniform rates," all customers in a uniform rate area pay the same rates for
water and wastewater services. In response to the Court of Appeals' order, in
August 1996 the FPSC ordered Florida Water to issue refunds to those customers
who paid more since October 1993 under uniform rates than they would have paid
under stand-alone rates. This order did not permit a balancing surcharge to
customers who paid less under uniform rates. Florida Water appealed, and the
Court of Appeals ruled in June 1997 that the FPSC could not order refunds
without balancing surcharges. In response to the Court of Appeals' ruling, the
FPSC issued an order on Jan. 26, 1998, that would not require Florida Water to
refund about $12.5 million, which included interest, to customers who paid more
under uniform rates.
Also on Jan. 26, 1998, the FPSC ordered Florida Water to refund $2.5 million,
the amount paid by customers in the Spring Hill service area from January 1996
through June 1997 under uniform rates which exceeded the amount these customers
would have paid under a modified stand-alone rate structure. No balancing
surcharge was permitted. The FPSC ordered this refund because Spring Hill
customers continued to pay uniform rates after other customers began paying
modified stand-alone rates effective January 1996 pursuant to the FPSC's interim
rate order in Florida Water's 1995 Rate Case. The FPSC did not include Spring
Hill in this interim rate order because Hernando County had assumed jurisdiction
over Spring Hill's rates. In June 1997 Florida Water reached an agreement with
Hernando County to revert to stand-alone rates for Spring Hill customers. The
Company intends to appeal the $2.5 million refund. No provision for refund has
been recorded.
DEFERRED REGULATORY CHARGES AND CREDITS. Based on current rate treatment, the
Company believes all deferred regulatory charges are probable of recovery.
Deferred Regulatory
Charges and Credits
December 31 1997 1996
- ---------------------------------------------------------------
Millions
Deferred charges
Income taxes $21.5 $22.1
Conservation improvement programs 17.7 21.3
Early retirement plan 2.8 8.2
Postretirement benefits 5.4 8.1
Premium on reacquired debt 6.9 7.5
Other 10.1 16.3
----- -----
64.4 83.5
Deferred credits
Income taxes 60.7 64.4
----- -----
Net deferred regulatory charges $ 3.7 $19.1
- ---------------------------------------------------------------
-25-
<PAGE>
5
SQUARE BUTTE PURCHASED POWER CONTRACT
Under the terms of a 30-year contract with Square Butte that extends through
2007, the Company is purchasing 71% of the output from a mine-mouth,
lignite-fired generating plant capable of generating up to 470 MW. This
generating unit (Project) is located near Center, North Dakota. Reductions to
about 49% of the output are provided for in the contract and, at the option of
Square Butte, could begin after a five-year advance notice to the Company and
continue for the remaining economic life of the Project. The Company has the
option but not the obligation to continue to purchase 49% of the output after
2007.
The Project is leased to Square Butte through Dec. 31, 2007, by certain banks
and their affiliates which have beneficial ownership in the Project. Square
Butte has options to renew the lease after 2007 for essentially the entire
remaining economic life of the Project.
The Company is obligated to pay Square Butte all Square Butte's leasing,
operating and debt service costs (less any amounts collected from the sale of
power or energy to others) that shall not have been paid by Square Butte when
due. These costs include the price of lignite coal purchased by Square Butte
under a cost-plus contract with BNI Coal. The Company's cost of power and energy
purchased from Square Butte during 1997 was $56.9 million ($58.2 million in
1996; $57.6 million in 1995). The leasing costs of Square Butte included in the
cost of power delivered to the Company totaled $17.1 million in 1997 ($17.7
million in 1996; $19.3 million in 1995), which included approximately $9 million
($10.2 million in 1996; $11 million in 1995) of interest expense. The annual
fixed lease obligations of the Company for Square Butte are $17.2 million from
1998 through 2002. At Dec. 31, 1997, Square Butte had total debt outstanding of
$250 million. The Company's obligation is absolute and unconditional whether or
not any power is actually delivered to the Company.
The Company's payments to Square Butte for power and energy are approved as
purchased power expense for ratemaking purposes by both the MPUC and FERC.
One principal reason the Company entered into the agreement with Square Butte
was to obtain a power supply for large industrial customers. Present electric
service contracts with these customers require payment of minimum monthly demand
charges that cover a portion of the fixed costs associated with having capacity
available to serve them. These contracts minimize the negative impact on
earnings that could result from significant reductions in kilowatthour sales to
industrial customers. The initial minimum contract term for the large power
customers is 10 years, with a four-year cancellation notice required for
termination of the contract at or beyond the end of the tenth year. Under the
terms of existing contracts as of Feb. 1, 1998, the Company would collect
approximately $92.1 million under current rate levels for firm power during 1998
($78.3 million in 1999; $69.2 million in 2000; $66.5 million in 2001; and $47.3
million in 2002), even if no power or energy were supplied to these customers
after Dec. 31, 1997. The minimum contract provisions are expressed in megawatts
of demand, and if rates change, the amounts the Company would collect under the
contracts will change in proportion to the change in the demand rate.
6
JOINTLY OWNED ELECTRIC FACILITY
The Company owns 80% of Boswell Energy Center Unit 4 (Boswell Unit 4). While the
Company operates the plant, certain decisions with respect to the operations of
Boswell Unit 4 are subject to the oversight of a committee on which the Company
and Wisconsin Public Power, Inc. SYSTEM (WPPI), the owner of the other 20% of
Boswell Unit 4, have equal representation and voting rights. Each owner must
provide its own financing and is obligated to pay its ownership share of
operating costs. The Company's share of direct operating expenses of Boswell
Unit 4 is included in operating expense on the consolidated statement of income.
The Company's 80% share of the original cost included in electric plant at Dec.
31, 1997 was $305 million ($304 million at Dec. 31, 1996). The corresponding
provision for accumulated depreciation was $136 million ($129 million at Dec.
31, 1996).
-26-
<PAGE>
7
FINANCIAL INSTRUMENTS
SECURITIES INVESTMENTS. Securities investments, managed internally and also by
external fund managers, consist primarily of equity securities of other
utilities with investment grade debt ratings. Investments held principally for
near-term sale are classified as trading securities and included in current
assets at fair value. Changes in the fair value of trading securities are
recognized currently in earnings. Investments held for an indefinite period of
time are classified as available-for-sale securities and included in plant and
investments at fair value. Unrealized gains and losses on available-for-sale
securities are included in common stock equity, net of tax. Unrealized losses on
available-for-sale securities that are other than temporary are recognized in
earnings. Realized gains and losses are computed on each specific investment
sold.
Available-For-Sale Securities
- ---------------------------------------------------------------
Gross Unrealized Fair
----------------
Cost Gain (Loss) Value
- ---------------------------------------------------------------
Millions
Equity securities
Dec. 31, 1997 $60.5 $4.3 $(3.5) $61.3
Dec. 31, 1996 $68.0 $1.9 $(2.1) $67.8
Year Ended December 31 1997 1996 1995
- ---------------------------------------------------------------
Millions
Proceeds from sales $47.7 $43.1 $97.1
Gross realized gains $0.7 $0.9 $3.0
Gross realized (losses) $(1.4) $(1.4) $(3.3)
Net unrealized holding gains
in common stock equity $0.2 $1.0 $0.9
- ---------------------------------------------------------------
At Dec. 31, 1997, the net unrealized gain on securities investments recorded in
common stock equity also included $5 million ($2.8 million at Dec. 31, 1996)
reflecting the Company's share of Capital Re's net unrealized holding gains. The
net unrealized holding gains included in earnings for trading securities in 1997
were $2 million ($0.9 million in 1996; $1.5 million in 1995).
FAIR VALUE OF FINANCIAL INSTRUMENTS. With the exception of the items listed
below, the estimated fair values of all financial instruments approximate the
carrying amount. The fair values for the items below were based on quoted market
prices for the same or similar instruments.
Financial Instruments
December 31 1997 1996
- ------------------------------------------------------------------------
Millions
Carrying Fair Carrying Fair
Amount Value Amount Value
- ------------------------------------------------------------------------
Long-term debt $685.4 $707.4 $694.4 $690.7
Redeemable serial
preferred stock $20.0 $21.5 $20.0 $21.2
Quarterly income
preferred securities $75.0 $76.9 $75.0 $73.9
- ------------------------------------------------------------------------
CONCENTRATION OF CREDIT RISK. Financial instruments that subject the Company to
concentrations of credit risk consist primarily of accounts receivable. The
Company sells electricity to about 15 customers in northern Minnesota's
taconite, pipeline, paper and wood products industries. At Dec. 31, 1997,
receivables from these customers totaled approximately $9 million ($8 million in
1996). The Company does not obtain collateral to support utility receivables,
but monitors the credit standing of major customers. The Company has not
incurred and does not expect to incur significant credit losses.
SALE OF FINANCE RECEIVABLES. In 1997 AFC amended an agreement to allow sales up
to $225 million, previously $100 million, of finance receivables to a third
party. Pursuant to this agreement, AFC has sold $124 million of receivables as
of Dec. 31, 1997 ($50 million as of Dec. 31, 1996). The agreement expires at
the end of 2001.
OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS AND RISKS. In portfolio strategies
designed to reduce market risks, the Company sells common stock securities short
and enters into short sales of treasury futures contracts. Selling common stock
securities short is intended to reduce market price risks associated with
holding common stock securities in the Company's trading securities portfolio.
Realized and unrealized gains and losses from short sales of common stock
securities are included in investment income. Treasury futures are used as a
hedge to reduce interest rate risks associated with holding fixed dividend
preferred stocks included in the Company's available-for-sale portfolio. Changes
in market values of treasury futures are recognized as an adjustment to the
carrying amount of the underlying hedged item. Gains and losses on treasury
futures are deferred and recognized in investment income concurrently with gains
and losses arising from the under-
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<PAGE>
lying hedged item. Generally, treasury futures contracts entered into have a
maturity date of 90 days.
In 1997 Florida Water restructured an interest rate swap agreement to take
advantage of more favorable terms. Under the new five-year agreement, Florida
Water will make quarterly payments at a variable rate based upon an average of
various foreign LIBOR rates (3.7% at Dec. 31, 1997), and receive payments based
on a fixed rate of 4.8%. This agreement is subject to market risk due to
interest rate fluctuation.
The notional amounts summarized below do not represent amounts exchanged and are
not a measure of the Company's financial exposure. The amounts exchanged are
calculated on the basis of these notional amounts and other terms which relate
to the change in interest rates or securities prices. The Company continually
evaluates the credit standing of counterparties and market conditions, and does
not expect any material adverse impact to its financial position from these
financial instruments.
Off-Balance-Sheet
Financial Instruments
December 31 1997 1996
- --------------------------------------------------------------
Millions
Fair Fair
Value Value
Notional Benefit Notional Benefit
Amount (Obligation) Amount (Obligation)
- --------------------------------------------------------------
Short stock sales
outstanding $54.0 $(2.7) $31.7 $ 0.0
Treasury futures $22.8 $(0.4) $20.8 $(0.1)
Interest rate swap $30.0 $(0.2) $30.0 $0.1
- --------------------------------------------------------------
8
SHORT-TERM BORROWINGS AND COMPENSATING BALANCES
The Company has bank lines of credit, which make short-term financing available
through short-term bank loans and provide support for commercial paper. At Dec.
31, 1997 and 1996, the Company had bank lines of credit aggregating $84 million.
At the end of 1997 and 1996, $84 million was available for use. At Dec. 31,
1997, the Company had issued commercial paper with a face value of $130 million
($155 million in 1996), with liquidity provided by bank lines of credit and the
Company's securities portfolio.
Certain lines of credit require a commitment fee of 1/10 of 1% and/or a 5%
compensating balance. Interest rates on commercial paper and borrowings under
the lines of credit ranged from 6.1% to 8.5% at Dec. 31, 1997 (5.6% to 8.3% at
Dec. 31, 1996). The weighted average interest rate on short-term borrowings at
Dec. 31, 1997, was 6.3% (5.7% at Dec. 31, 1996). The total amount of
compensating balances at Dec. 31, 1997 and 1996, was immaterial.
9
INVESTMENT IN CAPITAL RE
The Company has a 21% equity investment in Capital Re, a company engaged in
financial guaranty reinsurance and insurance. The Company uses the equity method
to account for this investment.
Capital Re
Financial Information
Year Ended December 31 1997 1996 1995
- --------------------------------------------------------------------
Millions
Capital Re
Investment portfolio $1,011.1 $901.1 $771.8
Other assets $376.9 $255.3 $210.1
Liabilities $341.9 $255.0 $180.5
Deferred revenue $402.1 $337.1 $314.5
Net revenue $201.7 $144.9 $107.0
Net income $70.1 $56.5 $45.5
Minnesota Power's Interest
Equity in earnings $14.8 $11.8 $9.8
Accumulated equity in
undistributed earnings $67.5 $53.7 $42.8
Equity investment $118.8 $102.3 $92.9
Fair value of investment $202.6 $152.3 $100.4
Equity ownership 21% 21% 22%
- --------------------------------------------------------------------
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<PAGE>
10
COMMON STOCK AND RETAINED EARNINGS
The Articles of Incorporation, mortgage, and preferred stock purchase agreements
contain provisions that, under certain circumstances, would restrict the payment
of common stock dividends. As of Dec. 31, 1997, no retained earnings were
restricted as a result of these provisions.
Summary of Common Stock Shares Equity
- --------------------------------------------------------------
Millions
Balance Dec. 31, 1994 31.3 $371.2
1995 ESPP - 0.8
DRIP 0.2 5.7
---- ------
Balance Dec. 31, 1995 31.5 377.7
1996 ESPP - 0.7
DRIP 0.7 18.5
Other 0.6 (2.7)
---- ------
Balance Dec. 31, 1996 32.8 394.2
1997 ESPP - 0.9
DRIP 0.6 18.6
Other 0.2 2.3
---- ------
Balance Dec. 31, 1997 33.6 $416.0
- --------------------------------------------------------------
SHAREHOLDER RIGHTS PLAN. On July 24, 1996, the Board of Directors of the Company
adopted a rights plan (Rights Plan) pursuant to which it declared a dividend
distribution of one preferred share purchase right (Right) for each outstanding
share of common stock to shareholders of record at the close of business on July
24, 1996, (the Record Date) and authorized the issuance of one Right with
respect to each share of common stock that becomes outstanding between the
Record Date and July 23, 2006, or such earlier time as the Rights are redeemed.
Each Right will be exercisable to purchase one one-hundredth of a share of
Junior Serial Preferred Stock A, without par value, at an exercise price of $90,
subject to adjustment, following a distribution date which shall be the earlier
to occur of (i) 10 days following a public announcement that a person or group
(Acquiring Person) has acquired, or obtained the right to acquire, beneficial
ownership of 15% or more of the outstanding shares of common stock (Stock
Acquisition Date) or (ii) 15 business days (or such later date as may be
determined by the Board of Directors prior to the time that any person becomes
an Acquiring Person) following the commencement of, or a public announcement of
an intention to make, a tender or exchange offer if, upon consummation thereof,
such person would meet the 15% threshold.
Subject to certain exempt transactions, in the event that the 15% threshold is
met, each holder of a Right (other than the Acquiring Person) will thereafter
have the right to receive, upon exercise at the then current exercise price of
the Right, common stock (or, in certain circumstances, cash, property or other
securities of the Company) having a value equal to two times the exercise price
of the Right. If, at any time following the Stock Acquisition Date, the Company
is acquired in a merger or other business combination transaction or 50% or more
of the Company's assets or earning power are sold, each Right will entitle the
holder (other than the Acquiring Person) to receive, upon exercise at the then
current exercise price of the Right, common stock of the acquiring or surviving
company having a value equal to two times the exercise price of the Right.
Certain stock acquisitions will also trigger a provision permitting the Board of
Directors to exchange each Right for one share of common stock.
The Rights are nonvoting and expire on July 23, 2006, unless redeemed by the
Company at a price of $.01 per Right at any time prior to the time a person
becomes an Acquiring Person. The Board of Directors has authorized the
reservation of one million shares of Junior Serial Preferred Stock A for
issuance under the Rights Plan in the event of exercise of the Rights.
11
PREFERRED STOCK
Preferred Stock
December 31 1997 1996
- ---------------------------------------------------------------
Millions
Cumulative Preferred Stock
Preferred stock, $100 par value,
116,000 shares authorized;
5% Series - 113,358 shares outstanding,
callable at $102.50 per share $11.5 $11.5
- ---------------------------------------------------------------
Redeemable Serial Preferred Stock
Serial preferred stock A, without
par value, 2,500,000 shares authorized;
$6.70 Series - 100,000 shares
outstanding, noncallable, redeemable
in 2000 at $100 per share $10.0 $10.0
$7.125 Series - 100,000 shares
outstanding, noncallable, redeemable
in 2000 at $100 per share 10.0 10.0
----- -----
Total redeemable serial preferred stock $20.0 $20.0
- ---------------------------------------------------------------
-29-
<PAGE>
12
MANDATORILY REDEEMABLE PREFERRED SECURITIES OF SUBSIDIARY
MP&L Capital I (Trust) was established as a wholly owned business trust of the
Company for the purpose of issuing common and preferred securities (Trust
Securities). In March 1996 the Trust publicly issued three million 8.05%
Cumulative Quarterly Income Preferred Securities (QUIPS), representing preferred
beneficial interests in the assets held by the Trust. The proceeds of the sale
of the QUIPS, and of common securities of the Trust to the Company, were used by
the Trust to purchase from the Company $77.5 million of 8.05% Junior
Subordinated Debentures, Series A, Due 2015 (Subordinated Debentures), resulting
in net proceeds to the Company of $72.3 million. Holders of the QUIPS are
entitled to receive quarterly distributions at an annual rate of 8.05% of the
liquidation preference value of $25 per security. The Company has the right to
defer interest payments on the Subordinated Debentures which would result in the
similar deferral of distributions on the QUIPS during extension periods up to 20
consecutive quarters. The Company is the owner of all the common trust
securities, which constitute approximately 3% of the aggregate liquidation
amount of all the Trust Securities. The sole asset of the Trust is Subordinated
Debentures, interest on which is deductible by the Company for income tax
purposes. The Trust will use interest payments received on the Subordinated
Debentures it holds to make the quarterly cash distributions on the QUIPS.
The QUIPS are subject to mandatory redemption upon repayment of the Subordinated
Debentures at maturity or upon redemption. The Company has the option to redeem
the Subordinated Debentures upon the occurrence of certain events and, in any
event, may do so at any time on or after March 20, 2001.
The Company has guaranteed, on a subordinated basis, payment of the Trust's
obligations.
13
LONG-TERM DEBT
Long-Term Debt
December 31 1997 1996
- --------------------------------------------------------------
Millions
Minnesota Power
First mortgage bonds
6 1/4% Series due 2003 $ 25.0 $ 25.0
6.68% Series due 2007 20.0 -
7% Series due 2007 60.0 -
7 1/2% Series due 2007 35.0 35.0
7 3/4% Series due 2007 55.0 55.0
7% Series due 2008 50.0 50.0
6 1/2% Series - 18.0
7 3/8% Series - 60.0
6% Pollution control series E
due 2022 111.0 111.0
Variable demand revenue refunding
bonds series 1997 A, B, C and D,
due 2007-2020 39.0 -
Pollution control revenue bonds,
6.875%, due 2002 4.8 33.9
Leveraged ESOP loan,
9.125%, due 1998-2004 11.3 12.2
Other long-term debt, variable,
due 2001-2013 7.3 17.3
Subsidiary companies
First mortgage bonds,
8.46%, due 2013 54.9 45.0
Senior notes, series A,
7.70%, due 2006 90.0 90.0
Industrial development
revenue bonds, 6.50%, due 2025 35.1 33.6
First mortgage bonds, 8.01%, due 2017 28.0 -
Note payable, 10.44% - 30.0
Other long-term debt,
6.1-8 7/8%, due 1998-2026 63.7 85.6
Less due within one year (4.7) (7.2)
------ ------
Total long-term debt $685.4 $694.4
- --------------------------------------------------------------
The aggregate amount of long-term debt maturing during 1998 is $4.7 million
($6.6 million in 1999; $9.6 million in 2000; $11.1 million in 2001; and $14.0
million in 2002). Substantially all Company electric and water plant is subject
to the lien of the mortgages securing various first mortgage bonds.
At Dec. 31, 1997, subsidiaries of the Company had long-term bank lines of credit
aggregating $20 million ($50 million at Dec. 31, 1996). Drawn portions on these
lines of credit aggregate $4.5 million at Dec. 31, 1997 ($20 million at Dec. 31,
1996), and are included in subsidiary companies other long-term debt.
-30-
<PAGE>
14
LEASING AGREEMENTS
ADESA leases three auction facilities which have five year lease terms ending
2000 and no renewal options. At the beginning of the fourth year of the lease
term, in the event ADESA does not exercise its purchase option at an aggregate
price of $26.5 million, ADESA has guaranteed any deficiency in sales proceeds
the lessor realizes in disposing of the leased properties should the selling
price fall below $25.7 million. ADESA is entitled to any excess sales proceeds
over the option price. ADESA has guaranteed the payment of principal and
interest on the lessor's indebtedness which consists of $25.7 million of 9.82%
mortgage notes, due Aug. 1, 2000.
The Company leases other properties and equipment in addition to those listed
above pursuant to operating and capital lease agreements with terms expiring
through 2009. The aggregate amount of future minimum lease payments for capital
and operating leases during 1998 is $13.5 million ($14.2 million in 1999; $7.4
million in 2000; $4.8 million in 2001; and $4.1 million in 2002). Total rent
expense was $10 million in 1997 ($7.4 million in 1996; $1.6 million in 1995).
15
INCOME TAX EXPENSE
Income Tax Expense
Year Ended December 31 1997 1996 1995
- --------------------------------------------------------------
Millions
Continuing operations
Current tax expense
Federal $31.9 $23.6 $ 8.5
Foreign 3.1 1.7 0.6
State 10.0 6.1 4.2
----- ----- -----
45.0 31.4 13.3
----- ----- -----
Deferred tax expense (benefits)
Federal 4.8 0.3 6.8
State (1.5) (1.9) 0.3
----- ----- -----
3.3 (1.6) 7.1
----- ----- -----
Change in valuation allowance (0.4) (8.2) (18.4)
----- ----- -----
Deferred tax credits (1.3) (2.0) (0.9)
----- ----- -----
Income tax for
Continuing operations 46.6 19.6 1.1
Discontinued operations - - 2.9
----- ----- -----
Total income tax expense $46.6 $19.6 $ 4.0
- --------------------------------------------------------------
Reconciliation of Taxes from
Federal Statutory Rate to
Total Income Tax Expense
Year Ended December 31 1997 1996 1995
- --------------------------------------------------------------
Millions
Tax computed at federal
statutory rate $43.5 $31.1 $24.0
Increase (decrease) in tax
State income taxes, net of
federal income tax benefit 5.6 2.9 3.5
Change in valuation allowance (0.4) (8.2) (18.4)
Dividend received deduction (2.0) (1.9) (2.3)
Tax credits (2.2) (1.9) (1.9)
Other 2.1 (2.4) (0.9)
----- ----- -----
Total income tax expense $46.6 $19.6 $ 4.0
- --------------------------------------------------------------
Deferred Tax Assets
and Liabilities
December 31 1997 1996
- --------------------------------------------------------------
Millions
Deferred tax assets
Contributions in aid of construction $ 19.8 $ 18.8
Lehigh basis difference 15.3 23.6
Deferred compensation plans 15.6 12.1
Depreciation 12.9 15.0
Investment tax credits 22.2 22.8
Other 41.4 35.1
------ ------
Gross deferred tax assets 127.2 127.4
Deferred tax asset valuation allowance (0.3) (0.7)
------ ------
Total deferred tax assets 126.9 126.7
------ ------
Deferred tax liabilities
Depreciation 200.3 188.8
Allowance for funds used
during construction 18.2 18.7
Income from unconsolidated subsidiaries 7.7 5.4
Investment tax credits 31.3 32.6
Other 20.7 30.1
------ ------
Total deferred tax liabilities 278.2 275.6
------ ------
Accumulated deferred income taxes $151.3 $148.9
- --------------------------------------------------------------
TAX BENEFITS. The Company, through Lehigh, acquired the stock of Lehigh
Corporation in a bargain purchase in 1991. The carried-over tax bases of the
underlying assets exceeded the book bases assigned in purchase accounting. The
Internal Revenue Code (IRC) limits the use of tax losses resulting from the
higher tax basis.
SFAS 109, "Accounting for Income Taxes," was adopted on a prospective basis
effective Jan. 1, 1993. Upon adoption, a valuation reserve was established for
the entire amount of the tax benefits attributable to the bases differences and
alternative minimum tax credits because, in management's
-31-
<PAGE>
judgment, realization of the tax benefits was not "more likely than not." This
judgment was based on the unlikelihood of realizing the tax benefits due to the
IRC restrictions in light of management's existing five year property disposal
plan.
In 1995 based on a detailed analysis of projected cash flow, Lehigh implemented
a business strategy which called for Lehigh to dispose of its remaining real
estate assets with a specific view towards maximizing realization of the tax
benefits. Accordingly, in 1995 the valuation reserve was reduced by $18.4
million. In 1996 the remaining $8.2 million valuation reserve was reversed as a
result of the projected positive impact the 1996 Palm Coast acquisition would
have on Lehigh's taxable income.
UNDISTRIBUTED EARNINGS. No provision has been made for taxes on $19.1 million of
pre-1993 undistributed earnings of Capital Re, an investment accounted for under
the equity method. Those earnings have been and are expected to continue to be
reinvested. The Company estimates that $7.9 million of tax would be payable on
the pre-1993 undistributed earnings of Capital Re if the Company should sell its
investment. The Company has recognized the income tax impact on undistributed
earnings of Capital Re earned since Jan. 1, 1993.
Undistributed earnings of the Company's foreign subsidiaries were approximately
$6.6 million at Dec. 31, 1997 ($4.2 million at Dec. 31, 1996). Foreign
undistributed earnings are considered to be indefinitely reinvested, and,
accordingly, no provision for U.S. federal and state income taxes has been
provided thereon. Upon distribution of foreign undistributed earnings in the
form of dividends or otherwise, the Company would be subject to both U.S. income
tax (subject to an adjustment, for foreign tax credits) and withholding taxes
payable to Canada. Determination of the amount of unrecognized deferred U.S.
income tax liability is not practical due to the complexities associated with
its hypothetical calculations; however, unrecognized foreign tax credit
carryforwards would be available to reduce some portion of the U.S. liability.
Withholding taxes of approximately $0.3 million would be payable upon remittance
of all previously unremitted earnings at Dec. 31, 1997 ($0.2 million at Dec. 31,
1996).
16
EMPLOYEE STOCK AND INCENTIVE PLANS
EMPLOYEE STOCK OWNERSHIP PLAN. The Company sponsors an Employee Stock Ownership
Plan (ESOP) with two leveraged accounts.
A 1989 leveraged ESOP account covers all eligible nonunion Minnesota and
Wisconsin utility and corporate employees. The ESOP used the proceeds from a
$16.5 million loan (15 year term at 9.125%), guaranteed by the Company, to
purchase 600,000 shares of Company common stock on the open market. These shares
fund an annual benefit of not less than 2% of participants' salaries.
A 1990 leveraged ESOP account covers Minnesota and Wisconsin utility and
corporate employees who participated in the non-leveraged ESOP plan prior to
August 1989. In 1990 the ESOP issued a $75 million note (term not to exceed 25
years at 10.25%) to the Company as consideration for 2.8 million shares of newly
issued common stock. These shares are used to fund an annual benefit at least
equal to the value of (a) dividends on shares held in the 1990 leveraged ESOP
which are used to make loan payments, and (b) tax benefits obtained from
deducting eligible dividends.
The loans will be repaid with dividends received by the ESOP and with employer
contributions. ESOP shares acquired with the loans were initially pledged as
collateral for the loans. The ESOP shares are released from collateral and
allocated to participants based on the portion of total debt service paid in the
year. The ESOP shares that collateralize the loans are not included in the
number of average shares used to calculate basic and diluted earnings per share.
ESOP Compensation and
Interest Expense
Year Ended December 31 1997 1996 1995
- --------------------------------------------------------------
Millions
Interest expense $1.1 $1.2 $1.3
Compensation expense 1.7 1.8 1.8
---- ---- ----
Total $2.8 $3.0 $3.1
- --------------------------------------------------------------
-32-
<PAGE>
ESOP Shares
December 31 1997 1996
- --------------------------------------------------------------
Millions
Allocated shares 1.8 1.8
Unreleased shares 2.5 2.6
--- ---
Total ESOP shares 4.3 4.4
- --------------------------------------------------------------
Fair value of unreleased shares $108.5 $71.9
- --------------------------------------------------------------
EMPLOYEE STOCK PURCHASE PLAN. The Company has an Employee Stock Purchase Plan
that permits eligible employees to buy up to $23,750 per year of Company common
stock at 95% of the market price. At Dec. 31, 1997, 476,000 shares had been
issued under the plan, and 168,000 shares were held in reserve for future
issuance.
STOCK OPTION AND AWARD PLANS. The Company has an Executive Long-Term Incentive
Compensation Plan and a Director Long-Term Stock Incentive Plan, both of which
became effective in January 1996. The Executive Plan allows for the grant of up
to 2.1 million shares of common stock to key employees of the Company. To date,
these grants have taken the form of stock options, performance share awards and
restricted stock awards. The Director Plan allows for the grant of up to 150,000
shares of common stock to nonemployee directors of the Company. Each nonemployee
director receives an annual grant of 725 stock options and a biennial grant of
performance shares equal to $10,000 in value of common stock at the date of
grant.
Stock options are exercisable at the market price of common shares on the date
the options are granted, and vest in equal annual installments over two years
with expiration ten years from the date of grant. Performance shares are earned
over multi-year time periods and are contingent upon the attainment of certain
performance goals of the Company. Restricted stock vests once certain periods of
time have elapsed.
The Company has elected to account for its stock-based compensation plans in
accordance with APB Opinion No. 25 "Accounting for Stock Issued to Employees,"
and accordingly, compensation expense has not been recognized for stock options
granted. Compensation expense is recognized over the vesting periods for
performance and restricted share awards based on the market value of the
Company's stock, and was approximately $4 million in 1997 ($1 million in 1996).
Pro forma net income and earnings per share under SFAS No. 123 "Accounting for
Stock-Based Compensation" have not been presented because such amounts are not
materially different from actual amounts reported. This may not be
representative of the pro forma effects for future years if additional awards
are granted.
In 1997 the Company granted approximately 244,000 stock options (127,000 in
1996), 26,000 performance share awards (74,000 in 1996), and 9,000 shares of
restricted stock (24,000 in 1996). The average fair value of options granted was
$6.54 ($6.76 in 1996). The average remaining contractual life of options
outstanding at the end of 1997 was 8.7 years (9 years in 1996). In January 1998
the Company granted stock options to purchase approximately 185,000 shares of
common stock and granted approximately 87,000 performance share awards.
17
PENSION PLANS AND BENEFITS
The Company's Minnesota and Wisconsin utility and corporate operations have
noncontributory defined benefit pension plans covering eligible employees.
Pension benefits are based on an employee's years of service and earnings. The
Company makes contributions to the plans consistent with the funding
requirements of employee benefit and tax law. Plan assets are invested primarily
in publicly traded equity and fixed income securities. At Dec. 31, 1997,
approximately 8% of plan assets were invested in Company common stock. Benefits
under the Company's noncontributory defined benefit pension plan for Florida
utility operations were frozen as of Dec. 31, 1996.
Pension Costs
Year Ended December 31 1997 1996 1995
- --------------------------------------------------------------
Millions
Service cost $ 3.6 $ 3.7 $ 4.3
Interest cost 15.8 15.1 13.0
Actual return on assets (51.1) (21.2) (34.5)
Net amortization and deferral 31.5 3.3 17.8
Amortization of early
retirement cost 4.8 4.7 2.0
----- ----- -----
Net cost $ 4.6 $ 5.6 $ 2.6
- --------------------------------------------------------------
-33-
<PAGE>
Pension Plans Funded Status
October 1 1997 1996
- --------------------------------------------------------------
Millions
Actuarial present value of benefit
obligations
Vested $(175.9) $(173.2)
Nonvested (12.1) (6.6)
------- -------
Accumulated benefit obligation (188.0) (179.8)
Additional amounts related to
future salary increases (30.8) (25.7)
------- -------
Projected benefit obligation (PBO) (218.8) (205.5)
------- -------
Plan assets at fair value 270.7 233.0
------- -------
Plan assets in excess of PBO 51.9 27.5
Unrecognized net gain (64.4) (40.9)
Unrecognized prior service cost 5.2 5.7
Unrecognized transition obligation 1.4 1.7
Unrecognized early retirement cost 2.8 7.5
------- -------
Pension asset (liability) included in
other assets (liabilities) $ (3.1) $ 1.5
- --------------------------------------------------------------
Actuarial assumptions
Discount rate 7.75% 8.0%
Average salary increases 6.0% 6.0%
Long-term rate of return on assets 9.0% 9.0%
- --------------------------------------------------------------
BNI Coal and subsidiaries in Automotive and Water Services have defined
contribution pension plans covering eligible employees. The aggregate annual
pension cost for these plans was $2.1 million ($0.9 million in 1996 and in
1995).
POSTRETIREMENT BENEFITS. The Company provides certain health care and life
insurance benefits for retired employees. Company policy is to fund
postretirement benefit costs, through Voluntary Employee Benefit Association
(VEBA) trusts and an irrevocable grantor trust (IGT), as the amounts are
collected in rates. Maximum tax deductible contributions are made to the VEBAs,
with remaining funds placed in the IGT until such time as they become tax
deductible. Funds in the IGT do not qualify as plan assets and are excluded from
assets in the table below. Plan assets are invested primarily in publicly traded
equity and fixed income securities. The regulatory asset for deferred
postretirement benefits is being amortized in electric rates over a five year
period which began in 1995.
Postretirement Benefit Costs
Year Ended December 31 1997 1996 1995
- ----------------------------------------------------------------------
Millions
Service cost $ 2.6 $ 2.7 $ 2.6
Interest cost 4.1 4.2 3.6
Actual return on assets (3.1) (1.0) (0.1)
Net amortization and deferral 3.7 2.5 1.2
----- ----- -----
Postretirement benefit cost 7.3 8.4 7.3
Amortization of regulatory asset 2.7 2.7 2.0
----- ----- -----
Net cost $10.0 $11.1 $9.3
- ----------------------------------------------------------------------
Postretirement Benefit Plan
Funded Status
October 1 1997 1996
- ----------------------------------------------------------------
Millions
Accumulated postretirement
benefit obligation (APBO)
Retirees $(28.1) $(29.6)
Fully eligible participants (11.1) (10.6)
Other active participants (11.4) (13.0)
------ ------
APBO (50.6) (53.2)
Plan assets at fair value 20.3 10.8
------ ------
APBO in excess of plan assets (30.3) (42.4)
Unrecognized gain (22.9) (15.4)
Unrecognized transition obligation 34.7 38.3
------ ------
Postretirement liability included in
other liabilities $(18.5) $(19.5)
- ----------------------------------------------------------------
Actuarial assumptions
Discount rate 7.75% 8.0%
Long-term rate of return on assets 9.0% 9.0%
- ----------------------------------------------------------------
The assumed health care cost trend rate used was 9.4%, gradually decreasing to
an ultimate rate of 5.3% by 2002. A 1% increase in the assumed health care cost
trend rate would result in a $4.6 million increase in the accumulated
postretirement benefit obligations (APBO) and a $0.8 million increase in total
service and interest costs.
18
QUARTERLY FINANCIAL DATA (UNAUDITED)
Information for any one quarterly period is not necessarily indicative of the
results which may be expected for the year.
Quarter
Ended March 31 June 30 Sept. 30 Dec. 31
- -----------------------------------------------------------------
Millions except earnings per share
1997
Operating revenue
and income $222.1 $230.4 $246.2 $254.9
Operating income $26.4 $32.8 $40.3 $30.7
Net Income $16.1 $18.7 $23.2 $19.6
Earnings available
for common stock $15.6 $18.2 $22.7 $19.1
Basic and diluted
earnings per share
of common stock $0.52 $0.60 $0.73 $0.62
- -----------------------------------------------------------------
1996
Operating revenue
and income $202.7 $208.5 $215.2 $220.6
Operating income $28.8 $21.1 $21.7 $21.9
Net Income $18.3 $14.8 $17.5 $18.6
Earnings available
for common stock $17.5 $14.2 $17.0 $18.1
Basic and diluted
earnings per share
of common stock $0.61 $0.49 $0.58 $0.60
- -----------------------------------------------------------------
-34-
<PAGE>
DEFINITIONS
These abbreviations or acronyms are used throughout this document.
Abbreviations
or Acronyms Term
- --------------------------------------------------------------------------------
ADESA ADESA Corporation
AFC Automotive Finance Corporation
APB Accounting Principles Board
Americas' Water Americas' Water Services Corporation
BNI Coal BNI Coal, Ltd.
Capital Re Capital Re Corporation
CIP Conservation Improvement Programs
Company Minnesota Power & Light Company and its Subsidiaries
DRIP Dividend Reinvestment and Stock Purchase Plan
ESOP Employee Stock Ownership Plan
ESPP Employee Stock Purchase Plan
FASB Financial Accounting Standards Board
FERC Federal Energy Regulatory Commission
Florida Water Florida Water Services Corporation
FPSC Florida Public Service Commission
Great Rigs Great Rigs Incorporated
Heater Heater Utilities, Inc.
ISI Instrumentation Services, Inc.
kWh Kilowatthour(s)
LaGrange LaGrange Waterworks Corporation
Lehigh Lehigh Acquisition Corporation
Minnesota Power Minnesota Power & Light Company and its Subsidiaries
MP Enterprises Minnesota Power Enterprises, Inc.
MP Telecom Minnesota Power Telecom, Inc.
MP Water MP Water Resources Group, Inc.
Resources
MPUC Minnesota Public Utilities Commission
MW Megawatt(s)
NCUC North Carolina Utilities Commission
Note ___ Note ___ to the consolidated financial statements in the
Minnesota Power 1997 Annual Report
PSCW Public Service Commission of Wisconsin
QUIPS Quarterly Income Preferred Securities
SFAS Statement of Financial
Accounting Standards No.
Square Butte Square Butte Electric Cooperative
SWL&P Superior Water, Light and
Power Company
U.S. Maintenance U.S. Maintenance and Management
and Management Services Corporation
-35-
<PAGE>
Exhibit 23
Consent of Independent Accountants
We hereby consent to the incorporation by reference in the Registration
Statement on Form S-8 (Nos. 33-51989, 33-32033, 333-16463, 333-16445) of
Minnesota Power & Light Company of our report dated January 26, 1998 appearing
on page 17 of Minnesota Power & Light Company's Current Report on Form 8-K,
dated February 20, 1998.
We also consent to the incorporation by reference in the Prospectus constituting
part of the Registration Statement on Form S-3 (Nos. 33-51941, 33-50143,
333-07963, 333-13445, 333-02109, 333-20745, 33-45551) of Minnesota Power & Light
Company of our report dated January 26, 1998 appearing on page 17 of Minnesota
Power & Light Company's Current Report on Form 8-K, dated February 20, 1998.
PRICE WATERHOUSE LLP
PRICE WATERHOUSE LLP
Minneapolis, Minnesota
February 20, 1998
<TABLE> <S> <C>
<ARTICLE> UT
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM MINNESOTA
POWER'S CONSOLIDATED BALANCE SHEET, STATEMENT OF INCOME, AND STATEMENT OF CASH
FLOW FOR THE PERIOD ENDED DECEMBER 31, 1997, AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<BOOK-VALUE> PER-BOOK
<TOTAL-NET-UTILITY-PLANT> 1,106
<OTHER-PROPERTY-AND-INVEST> 420
<TOTAL-CURRENT-ASSETS> 369
<TOTAL-DEFERRED-CHARGES> 64
<OTHER-ASSETS> 213
<TOTAL-ASSETS> 2,172
<COMMON> 416
<CAPITAL-SURPLUS-PAID-IN> 0
<RETAINED-EARNINGS> 296
<TOTAL-COMMON-STOCKHOLDERS-EQ> 651
75
32
<LONG-TERM-DEBT-NET> 685
<SHORT-TERM-NOTES> 129
<LONG-TERM-NOTES-PAYABLE> 0
<COMMERCIAL-PAPER-OBLIGATIONS> 0
<LONG-TERM-DEBT-CURRENT-PORT> 5
0
<CAPITAL-LEASE-OBLIGATIONS> 0
<LEASES-CURRENT> 0
<OTHER-ITEMS-CAPITAL-AND-LIAB> 534
<TOT-CAPITALIZATION-AND-LIAB> 2,172
<GROSS-OPERATING-REVENUE> 954
<INCOME-TAX-EXPENSE> 47
<OTHER-OPERATING-EXPENSES> 774
<TOTAL-OPERATING-EXPENSES> 838
<OPERATING-INCOME-LOSS> 130
<OTHER-INCOME-NET> 9<F1>
<INCOME-BEFORE-INTEREST-EXPEN> 142
<TOTAL-INTEREST-EXPENSE> 64
<NET-INCOME> 78
2
<EARNINGS-AVAILABLE-FOR-COMM> 76
<COMMON-STOCK-DIVIDENDS> 63
<TOTAL-INTEREST-ON-BONDS> 49
<CASH-FLOW-OPERATIONS> 117
<EPS-PRIMARY> 2.47
<EPS-DILUTED> 2.47
<FN>
<F1>Includes $15 million of Income from Equity Investments and $6 million for
Distributions on Redeemable Preferred Securities of Subsidiary.
</FN>
</TABLE>
