<PAGE>
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark one)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 1998
---------------------------------------------
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
---------------- -----------------
Commission file number 0-15472
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ENVIRONMENTAL POWER CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 04-2782065
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
500 Market Street, Suite 1-E, Portsmouth, New Hampshire 03801
(Address of principal executive offices)
(Zip code)
(603) 431-1780
Registrant's telephone number, including area code
- --------------------------------------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Number of shares of Common Stock outstanding
at November 9, 1998 11,406,783 shares
The Exhibit Index appears on Page 32.
Total number of pages is 33.
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1
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ENVIRONMENTAL POWER CORPORATION
INDEX
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION Page No.
--------
<S> <C>
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as
of September 30, 1998 (unaudited) and December 31, 1997............................... 2
Condensed Consolidated Statements of Operations (unaudited) for the Three and Nine
months Ended September 30, 1998 and September 30, 1997................................ 3
Condensed Consolidated Statements of Cash Flows (unaudited) for the Three and Nine
months Ended September 30, 1998 and September 30, 1997................................ 4
Notes to Condensed Consolidated Financial Statements.................................. 5-6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations............................................................................ 7-29
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................... 30-32
Item 6. Exhibits and Reports on Form 8-K................................ 32
Signatures ................................................................ 33
</TABLE>
1
<PAGE>
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
September 30 December 31
1998 1997
----------------- ------------------
ASSETS (Unaudited)
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents $ 366,366 $ 12,092,273
Restricted cash 698,978 486,659
Receivable from utility 6,223,922 6,538,645
Notes receivable 41,539 39,128
Other current assets 784,804 881,938
----------------- ------------------
TOTAL CURRENT ASSETS 8,115,609 20,038,643
PROPERTY, PLANT AND EQUIPMENT, NET 104,853 129,936
DEFERRED INCOME TAX ASSET 1,073,755 817,755
LEASE RIGHTS, NET 2,645,766 2,757,519
RECEIVABLE FROM SALE OF AFFILIATE 570,998 570,998
NOTES RECEIVABLE 2,952,099 2,983,562
ACCRUED POWER GENERATION REVENUES 39,380,472 33,362,389
OTHER ASSETS 635,345 701,437
----------------- ------------------
$ 55,478,897 $ 61,362,239
================= ==================
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 5,524,720 $ 6,325,062
Dividends payable on common stock 171,102 10,266,105
Other current liabilities 4,005,998 2,911,666
----------------- ------------------
TOTAL CURRENT LIABILITIES 9,701,820 19,502,833
DEFERRED GAIN, NET 5,474,290 5,705,598
SECURED PROMISSORY NOTES PAYABLE
AND OTHER BORROWINGS 3,482,246 4,673,727
ACCRUED LEASE EXPENSES 39,380,472 33,362,389
MAINTENANCE RESERVE 2,120,900 1,995,818
----------------- ------------------
TOTAL LIABILITIES 60,159,728 65,240,365
SHAREHOLDERS' DEFICIT
Preferred Stock ($.01 par value; 1,000,000 shares authorized; no shares
issued at September 30, 1998 and December 31, 1997, respectively) -- --
Preferred Stock (no par value, 10 shares authorized; 10 shares
issued at September 30, 1998 and December 31, 1997, respectively) 100 100
Common Stock ($.01 par value; 20,000,000 shares authorized;
12,525,423 shares issued at September 30, 1998 and December 31, 1997,
respectively; 11,406,783 shares outstanding at September 30, 1998 and
December 31, 1997, respectively) 125,254 125,254
Additional paid-in capital 0 0
Accumulated deficit (3,540,183) (2,737,478)
----------------- ------------------
(3,414,829) (2,612,124)
Treasury stock (1,118,640 common shares, at cost, as of
September 30, 1998 and December 31, 1997, respectively) (456,271) (456,271)
Notes receivable from officers and board members (809,731) (809,731)
----------------- ------------------
TOTAL SHAREHOLDERS' DEFICIT (4,680,831) (3,878,126)
----------------- ------------------
$ 55,478,897 $ 61,362,239
================= ==================
</TABLE>
See notes to condensed consolidated financial statements.
2
<PAGE>
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended September 30
------------------------------------------
1998 1997
------------------- ------------------
<S> <C> <C>
POWER GENERATION REVENUES $ 11,820,273 $ 12,195,445
------------------- ------------------
COSTS AND EXPENSES:
Operating expenses 4,875,561 4,494,388
Lease expenses 5,579,583 6,510,104
General and administrative expenses 550,397 260,857
Reversal of provision for nonrecovery of
project development costs (940,144)
Depreciation and amortization 69,693 76,433
------------------- ------------------
11,075,234 10,401,638
------------------- ------------------
OPERATING INCOME (LOSS) 745,039 1,793,807
OTHER INCOME (EXPENSE):
Interest income 34,506 31,459
Interest expense (122,313) (125,451)
Amortization of deferred gain 77,103 77,103
Other income 10,847 ----
------------------- ------------------
143 (16,889)
------------------- ------------------
INCOME (LOSS) BEFORE INCOME TAXES 745,182 1,776,918
INCOME TAX (EXPENSE) BENEFIT (308,000) (674,000)
------------------- ------------------
NET INCOME (LOSS) $ 437,182 $ 1,102,918
=================== ==================
BASIC AND DILUTED EARNINGS (LOSS)
PER COMMON SHARE $ 0.04 $ 0.10
=================== ==================
DIVIDENDS PAID OR PAYABLE
Common shares $ 171,102 $ 335,153
Preferred shares 1,250 1,250
=================== ==================
$ 172,352 $ 336,403
=================== ==================
DIVIDENDS PAID OR PAYABLE PER
COMMON SHARE $ 0.015 $ 0.030
=================== ==================
<CAPTION>
Nine Months Ended September 30
------------------------------------------
1998 1997
------------------- ------------------
<S> <C> <C>
POWER GENERATION REVENUES $ 33,545,710 $ 31,500,839
------------------- ------------------
COSTS AND EXPENSES:
Operating expenses 14,313,809 13,559,961
Lease expenses 17,301,399 17,982,701
General and administrative expenses 1,646,989 1,432,677
Reversal of provision for nonrecovery of
project development costs (940,144)
Depreciation and amortization 215,779 181,633
------------------- ------------------
33,477,976 32,216,828
------------------- ------------------
OPERATING INCOME (LOSS) 67,734 (715,989)
OTHER INCOME (EXPENSE):
Interest income 127,734 175,932
Interest expense (357,164) (270,139)
Amortization of deferred gain 231,308 231,308
Other income 13,442 ----
------------------- ------------------
15,320 137,101
------------------- ------------------
INCOME (LOSS) BEFORE INCOME TAXES 83,054 (578,888)
INCOME TAX (EXPENSE) BENEFIT (29,000) 292,000
------------------- ------------------
NET INCOME (LOSS) $ 54,054 $ (286,888)
=================== ==================
BASIC AND DILUTED EARNINGS (LOSS)
PER COMMON SHARE $ 0.00 $ (0.03)
=================== ==================
DIVIDENDS PAID OR PAYABLE
Common shares $ 855,509 $ 999,760
Preferred shares 3,750 28,928
=================== ==================
$ 859,259 $ 1,028,688
=================== ==================
DIVIDENDS PAID OR PAYABLE PER
COMMON SHARE $ 0.075 $ 0.090
=================== ==================
</TABLE>
See notes to condensed consolidated financial statements.
3
<PAGE>
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
<TABLE>
<CAPTION>
Nine Months Ended September 30
------------------------------------------
1998 1997
---------------- --------------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 54,054 $ (286,888)
Adjustments to reconcile net income (loss) to net cash
used by operating activities:
Depreciation and amortization 215,779 181,633
Deferred income taxes (256,000) (272,000)
Amortization of deferred gain (231,308) (231,308)
Reversal of provision for nonrecovery of project
development costs --- (940,144)
Accrued power generation revenues (6,018,083) (6,678,441)
Accrued lease expenses 6,018,083 6,678,441
Changes in operating assets and liabilities:
Decrease (increase) in receivable from utility 314,723 (759,063)
Decrease in other current assets 97,134 101,912
Increase in receivable from sale of affiliate --- (73,236)
Increase in other assets (7,654) (151,417)
Decrease in accounts payable and accrued
expenses (797,842) (495,239)
Increase in long-term liabilities 8,519 8,646
Increase in maintenance reserve 125,082 575,180
---------------- ----------------
Net cash used by operating activities (477,513) (2,341,924)
---------------- ----------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from the collection of notes receivable 29,052 26,825
(Increase) decrease in restricted cash (212,319) 313,256
Property, plant and equipment expenditures (5,197) (1,052,819)
---------------- ----------------
Net cash used in investing activities (188,464) (712,738)
---------------- ----------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Dividend payments (10,954,262) (1,028,688)
Net borrowings under working capital loan 494,332 368,903
Borrowings under long-term credit facility --- 3,000,000
Repayment of secured promissory notes payable and
other borrowings (600,000) ---
Proceeds from the issuance of common stock --- 7,362
---------------- ----------------
Net cash (used in) provided by financing
activities (11,059,930) 2,347,577
---------------- ----------------
DECREASE IN CASH AND CASH EQUIVALENTS (11,725,907) (707,085)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 12,092,273 1,178,524
---------------- ----------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 366,366 $ 471,439
================ ================
</TABLE>
See notes to condensed consolidated financial statements.
4
<PAGE>
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE A -- BASIS OF PRESENTATION
- -------------------------------
The accompanying unaudited condensed consolidated financial statements of
Environmental Power Corporation ("EPC") and its subsidiaries (the "Company")
have been prepared in accordance with the instructions to Form 10-Q and do not
include all of the information and footnotes required by generally accepted
accounting principles for annual financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation have been included. The results of operations
for the nine months ended September 30, 1998 are not necessarily indicative of
results to be expected for the year ending December 31, 1998. For further
information, refer to the consolidated financial statements and footnotes
included in the Company's Annual Report on Form 10-K for the year ended December
31, 1997.
NOTE B -- NEW ACCOUNTING STANDARD
- ---------------------------------
Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income". SFAS
No. 130 addresses the reporting and display of comprehensive income and its
components. SFAS No 130 divides comprehensive income into two categories which
are "net income" and "other comprehensive income". The category known as "other
comprehensive income" refers to all changes in stockholders' equity during a
period except changes resulting from net income or loss, investments by
stockholders and distributions to stockholders. There were no items of other
comprehensive income, as defined by SFAS No. 130, to report during the nine
months ended September 30, 1998 and September 30, 1997.
NOTE C -- EARNINGS PER COMMON SHARE
- -----------------------------------
The Company computes its earnings (loss) per common share using the
treasury stock method in accordance with SFAS No. 128, "Earnings per Share".
The Company computes basic earnings (loss) per share by dividing net income
(loss) for the period by the weighted average number of shares of common stock
outstanding during the period. For purposes of calculating diluted earnings
(loss) per share, the Company considers its shares issuable in connection with
stock options to be dilutive common stock equivalents when the exercise price is
less than the average market price of the Company's common stock for the period.
The following tables outline the calculation of basic earnings (loss) per share
and diluted earnings (loss) per share for the three and nine months ended
September 30, 1998 and 1997.
5
<PAGE>
<TABLE>
<CAPTION>
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNTS
------------------ -------------------- ---------------
<S> <C> <C> <C>
THREE MONTHS ENDED SEPTEMBER 30, 1998:
- --------------------------------------
Income available to shareholders $ 437,182 11,406,783 $.04
Effect of dividends to preferred stockholders (1,250)
------------------ -------------------- ---------------
Basic EPS - income available to common shareholders 435,932 11,406,783 .04
Effect of dilutive securities:
Assumed exercise of dilutive stock options 22,597
------------------ -------------------- ---------------
Diluted EPS - income available to common shareholders $ 435,932 11,429,380 $.04
================== ==================== ===============
THREE MONTHS ENDED SEPTEMBER 30, 1997:
- --------------------------------------
Income available to shareholders $1,102,918 11,097,870 $.10
Effect of dividends to preferred stockholders (1,250)
------------------ -------------------- ---------------
Basic EPS - income available to common shareholders 1,101,668 11,097,870 .10
Effect of dilutive securities:
Assumed exercise of dilutive stock options 147,365
------------------ -------------------- ---------------
Diluted EPS - income available to common shareholders $1,101,668 11,245,235 $.10
================== ==================== ===============
<CAPTION>
INCOME (LOSS) SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNTS
------------------ -------------------- ---------------
<S> <C> <C> <C>
NINE MONTHS ENDED SEPTEMBER 30, 1998:
- -------------------------------------
Income available to shareholders $ 54,054 11,406,783 $ ---
Effect of dividends to preferred stockholders (3,750)
------------------ -------------------- ---------------
Basic EPS - income available to common shareholders 50,304 11,406,783 ---
Effect of dilutive securities:
Assumed exercise of dilutive stock options 22,595
------------------ -------------------- ---------------
Diluted EPS - income available to common shareholders $ 50,304 11,429,378 $ ---
================== ==================== ===============
NINE MONTHS ENDED SEPTEMBER 30, 1997:
- -------------------------------------
Loss available to shareholders $(286,888) 11,083,889 $(.03)
Effect of dividends to preferred stockholders (28,928)
------------------ -------------------- ---------------
Basic EPS - loss available to common shareholders (315,816) 11,083,889 (.03)
Effect of dilutive securities:
Assumed exercise of dilutive stock options 134,137
------------------ -------------------- ---------------
Diluted EPS - loss available to common shareholders $(315,816) 11,218,026 $(.03)
================== ==================== ===============
</TABLE>
NOTE D--RECLASSIFICATIONS
- -------------------------
The Company has made certain reclassifications to the consolidated financial
statements as of December 31, 1997 and for the three and nine months ended
September 30, 1997 in order to conform to the presentation of the consolidated
financial statements as of September 30, 1998 and for the three and nine months
ended September 30, 1998.
6
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
OVERVIEW OF THE COMPANY
The Company owns a 22 year leasehold interest in an approximately 83 Mw
(net) waste coal-fired electric generating facility (the "Scrubgrass Project")
located in Pennsylvania, the lease for which commenced on June 30, 1994. Until
December 31, 1994 the Company also held varying ownership interests (100% to
approximately 40%) in and oversaw the operation of an approximately 51 Mw (net)
waste coal-fired electric generating facility (the "Sunnyside Project") located
in Utah. Until December 5, 1997, the Company had one additional project (the
"Milesburg Project") which had been in the development stage since 1987 and
involved in significant contract litigation since the early stages of its
development activities. On August 26, 1997, the Company entered into a Buy-Out
Agreement with the utility which had contracted to purchase electricity from the
Milesburg Project. Under the terms of the Buy-Out Agreement, the Company sold
substantially all of the assets of the Milesburg project to this utility on
December 5, 1997 and terminated the ongoing litigation. As such, the Company's
power generation revenues, operating expenses and lease expenses during 1997 and
1998 pertain solely to the Scrubgrass Project. The following Management's
Discussion and Analysis of Financial Condition and Results of Operations
compares the Company's results of operations for the three and nine months ended
September 30, 1998 ("1998") to the three and nine months ended September 30,
1997 ("1997").
CAUTIONARY STATEMENT
This Quarterly Report on Form 10-Q contains "forward-looking statements",
as defined by the Private Securities Litigation Reform Act of 1995, in order to
provide investors with prospective information about the Company. For this
purpose, any statements which are not statements of historical fact may be
deemed to be forward-looking statements. Without limiting the foregoing, the
words "believes", "anticipates", "plans", "expects" and similar expressions are
intended to identify forward-looking statements. There are a number of
important factors which could cause the Company's actual results to differ
materially from those indicated by the forward looking statements. These
factors include, without limitation, those set forth below under the caption
"Certain Factors That May Affect Future Results".
RESULTS OF OPERATIONS
Revenues
Power generation revenues for the nine months ended September 30, 1998
amounted to $33,545,710 as compared to $31,500,839 for the nine months ended
September 30, 1997. The overall increase in power generation revenues during
1998 is primarily attributable to a 5% increase in certain rates billed to the
utility under the terms of the power purchase agreement and an increase in the
capacity rate billed during 1998. During the nine months ended September 30,
1998, the Scrubgrass Project operated at 85% of its capacity as compared to
81.3% for the same period in 1997. The following factors contributed principally
to the differences in the Scrubgrass Project's capacity factors billed for the
nine months ended September 30, 1998 by comparison to the same period in 1997.
First,
7
<PAGE>
the Scrubgrass project had its annual maintenance outages during the second
quarters in 1998 and 1997. During the 1998 outage, the Scrubgrass plant was
inoperative for approximately 14 days to perform scheduled maintenance
procedures whereas the 1997 maintenance outage was extended from 12 days to
approximately 37 days to perform more extensive repairs to the Scrubgrass
generator. Second, the Scrubgrass plant was inoperative for approximately 6 days
during the first quarter of 1997 to consider matters related to the generator.
Third, in the second quarter of 1998, the Scrubgrass project incurred several
unscheduled shutdowns to respond to equipment malfunctions which necessitated
that the Scrubgrass plant be inoperative for an aggregate of approximately 11
days outside of the scheduled outage timeframe. Fourth, in the third quarter of
1998, the Scrubgrass project incurred several unscheduled shutdowns to respond
to equipment malfunctions which necessitated that the Scrubgrass plant be
inoperative for an aggregate of approximately 7 days. As such, other than normal
curtailments of output from the utility which occurred from time to time, the
Scrubgrass plant did not operate for an aggregate of approximately 32 days and
43 days as a result of scheduled and unscheduled shutdowns during 1998 and 1997,
respectively. The aforementioned increase in 1998 power generation revenues was
offset in part by a decrease in the revenue recorded as a result of the
straight-line accounting treatment of certain revenues under the power purchase
agreement which amounted to $6,018,083 and $6,678,441 during the nine months
ended September 30, 1998 and September 30, 1997, respectively.
Power generation revenues for the three months ended September 30, 1998
amounted to $11,820,273 as compared to $12,195,445 for the three months ended
September 30, 1997. Power generation revenues decreased during the 1998 period
primarily for two reasons. First, due to several unscheduled shutdowns to
respond to equipment malfunctions and seven curtailments of output by the
utility, the Scrubgrass Project operated at 90.7% of its capacity during the
three months ended September 30, 1998 as compared to 97% for the same period in
1997. Second, the Company recognized a decrease in the revenue recorded as a
result of the straight-line accounting treatment of certain revenues under the
power purchase agreement which amounted to $2,006,028 and $2,227,470 for the
three months ended September 30, 1998 and September 30, 1997, respectively. The
aforementioned decrease in power generation revenues was offset in part because
the Company had a 5% increase in certain rates billed to the utility during 1998
under the terms of the power purchase agreement.
Operating Expenses
Operating expenses for the nine months ended September 30, 1998 amounted to
$14,313,809 as compared to $13,559,961 for the nine months ended September 30,
1997. The overall increase during 1998 is primarily attributable to the
following five reasons. First, the Company incurred higher fuel costs and
higher operator fees in 1998 as a result of cost escalations in certain
operating and supply agreements. Second, the Company incurred higher fuel
expenses because it achieved a higher capacity rate during 1998 and realized
lower average heat rates from fuel consumption in 1998 by comparison to 1997.
Third, because the Company is projecting higher overall operating performance
during 1998, the Company is accruing higher year-end operator bonuses during
1998 than were recorded in 1997. Fourth, although overall maintenance expenses
were higher in 1997 as discussed below, the Company did incur certain additional
maintenance expenses in 1998 by comparison to 1997 to make the necessary repairs
related to certain 1998 equipment malfunctions and to accelerate its reserves
for
8
<PAGE>
future maintenance which the Company now expects will be performed earlier than
its previous schedule. Finally, due to salary increases and increases in the
number of personnel at the Scrubgrass project, the Company incurred higher labor
and related costs in 1998. However, the aforementioned increases in 1998
operating expenses were offset in part because certain operating expenses were
higher during 1997 by comparison to 1998 primarily for the following reasons.
First, because of extensive repairs made during the 1997 extended outage, the
Company incurred additional maintenance expenses in 1997 by comparison to 1998.
Second, as a result of enhancements made during 1997 to the fuel processing
system at the Scrubgrass Project, the Company realized a savings in certain
routine maintenance expenses during 1998. Finally, the Company entered into
modifications to the financing contract with the manufacturer of the Scrubgrass
generator which reduced certain long-term liabilities and operating expenses
during the first quarter in 1998. See a further discussion of these
modifications under the caption "--Liquidity and Capital Resources--Cash Flow
Outlook".
Operating expenses for the three months ended September 30, 1998 amounted
to $4,875,561 as compared to $4,494,388 for the three months ended September 30,
1997. Similar to the discussion in the previous paragraph, operating expenses
for the three months ended September 30, 1998 also increased by comparison to
the same period in 1997 due to cost escalations in fuel and supply agreements,
higher labor costs, higher operator bonuses and higher maintenance expenses.
However, because the Scrubgrass Project operated at a reduced capacity rate, the
Company's variable fuel expenses were lower during the three months ended
September 30, 1998 when compared to the same period in 1997.
Lease Expense
Lease expense for the nine months ended September 30, 1998 amounted to
$17,301,399 as compared to $17,982,701 for the nine months ended September 30,
1997. The overall decrease in lease expense during 1998 is primarily due to the
following three reasons. First, because there was less cash available from the
Scrubgrass Project during 1998 (see a further discussion under "--Liquidity and
Capital Resources"), the Company realized a decrease in additional rent paid to
the Lessor. Second, due to favorable interest rates in 1998, the Company
realized a decrease in the Lessor's interest costs which were passed through to
the Company under the terms of its Scrubgrass facility lease. Third, the
Company had a decrease in the lease expense recorded as a result of the
straight-line accounting treatment of certain lease expenses under the
Scrubgrass lease which amounted to $6,018,083 and $6,678,441 for nine months
ended September 30, 1998 and September 30, 1997, respectively. The
aforementioned decrease in 1998 lease expense was offset in part by an increase
in scheduled base lease payments under the Scrubgrass lease and an increase in
scheduled principal payments for the Lessor's term loans which were passed
through to the Company under the terms of its Scrubgrass facility lease.
Lease expense for the three months ended September 30, 1998 amounted to
$5,579,583 as compared to $6,510,104 for the three months ended September 30,
1997. Similar to the discussion in the previous paragraph, lease expense for the
three months ended September 30, 1998 also decreased by comparison to the same
period in 1997 due to the decreases in additional rent, the Lessor's interest
costs and the lease expense recorded as a result of the straight-line accounting
treatment of certain lease expenses under the Scrubgrass lease which amounted to
$2,006,028 and $2,227,470 for the three months ended September 30, 1998 and
September 30, 1997, respectively. In addition, because the
9
<PAGE>
schedule of Scrubgrass base lease payments is uneven, the Company had lower
scheduled base lease payments under the Scrubgrass lease during the three months
ended September 30, 1998 by comparison to the same period in 1997. Such
decreases in lease expense during the three months ended September 30, 1998 were
offset in part by an increase in scheduled principal payments for the Lessor's
term loans which were passed through to the Company under the terms of its
Scrubgrass facility lease.
General and Administrative Expenses
General and administrative expenses for the nine months ended September 30,
1998 amounted to $1,646,989 as compared to $1,432,677 for the nine months ended
September 30, 1997. The overall increase in general and administrative expenses
during the 1998 nine month period is primarily attributable to the following
three factors. First, certain labor and overhead expenses, which were
capitalized in 1997 as a result of development activities for the Milesburg
project, were redirected to operating activities during 1998. Second, the
Scrubgrass project received a sales tax refund during the three months ended
September 30, 1997 which reduced general and administrative expenses by
comparison to the same period in 1998. Third, the management fees for the
Scrubgrass Project increased primarily because the project manager passed along
increases in its labor costs to the Company. However, the aforementioned
increases in 1998 general and administrative expenses were offset in part
because certain general and administrative expenses were lower during 1998 by
comparison to 1997 primarily for the following four reasons. First, the Company
incurred significant legal expenses in 1997 to review documents in the discovery
phase of the Sunnyside project litigation which expenses were incurred to a much
lesser extent during 1998. Second, while overall management costs were higher in
1998 as discussed above, the Company incurred significant management fees during
the nine months ended September 30, 1997 to address the Scrubgrass generator
matter and to consider other contract related matters, which matters either did
not recur or recurred to a lesser extent in 1998. Third, the Company
restructured its insurance programs at its corporate office and at the
Scrubgrass Project in April 1997 which resulted in lower insurance premiums for
1998 by comparison to 1997. Lastly, the Company reduced the amount of certain
professional fees during 1998 as compared to 1997 because it used such
professional services to a lesser extent during 1998.
General and administrative expenses for the three months ended September
30, 1998 amounted to $550,397 as compared to $260,857 for the three months ended
September 30, 1997. Similar to the discussion in the previous paragraph, general
and administrative expenses for the three months ended September 30, 1998 also
increased by comparison to the same period in 1997 due to the increase in
management fees, the sales tax refund received in 1997 and because certain labor
and overhead expenses, which were capitalized in 1997, were redirected to
operating activities in 1998. In addition, as discussed in the previous
paragraph, such increases were also offset in part by a reduction in legal
expenses, insurance expenses and professional fees during the three months ended
September 30, 1998.
10
<PAGE>
Reversal of Provision for Nonrecovery of Project Development Costs
Reversal of provision for nonrecovery of project development costs relates
to the Company's Milesburg Project and amounted to $940,144 for both the three
and nine months ended September 30, 1997. This provision was originally
established in 1990 by a charge against earnings when there was uncertainty
concerning whether the Company would realize the full value of its investment in
the Milesburg project. The provision was reversed in August 1997 when the
Company entered into an agreement to sell the Milesburg project at a substantial
profit.
Interest Income
Interest income for the three and nine months ended September 30, 1998
amounted to $34,506 and $127,734, respectively, as compared to $31,459 and
$175,932 for the three and nine months ended September 30, 1997, respectively.
The overall decrease in interest income for the nine months ended September 30,
1998 by comparison to the same period in 1997 is primarily attributable to less
interest recognized on the Company's notes receivable related to the sale of its
interest in the Sunnyside Project. Beginning in April 1997, as discussed in
previous filings, the Company has deferred the interest income on the notes
receivable related to the sale of its interest in the Sunnyside Project until
the litigation with the purchasers is resolved (See "Part II - Item 1. Legal
Proceedings" and "--Certain Factors That May Impact Future Results--Legal
Proceedings"). The aforementioned decrease in interest income during the 1998
nine month period was offset in part by higher interest earnings on the
Company's cash reserves and restricted cash which had higher average balances
during the 1998 nine month period. The interest related to the Sunnyside Project
did not effect the third quarter comparison because such interest was being
deferred during both the third quarters in 1998 and 1997.
Interest Expense
Interest expense for the nine months ended September 30, 1998 amounted to
$357,164 as compared to $270,139 for the nine months ended September 30, 1997.
Interest expense increased during 1998 primarily because of additional long-term
debt for the Scrubgrass Project which was incurred during the second quarter of
1997 to finance a cash deficiency which occurred shortly after the 1997 extended
maintenance outage. The additional long-term debt consists of a $3 million term
credit facility which is discussed further in the section "--Liquidity and
Capital Resources--Financing Activities" and installment debt which financed the
generator repair that is discussed further in the section "--Liquidity and
Capital Resources--Cash Flow Outlook". The aforementioned increase in interest
expense was offset in part by the following two decreases in interest expense
during 1998. First, due to lower average outstanding borrowings in 1998, the
Company incurred less interest on the Scrubgrass Project working capital loan
during 1998 by comparison to 1997. Second, due to favorable interest rates
during 1998, the Company had a general lowering of interest expense on its
variable rate loans.
Interest expense for the three months ended September 30, 1998 amounted to
$122,313 as compared to $125,451 for the three months ended September 30, 1997.
Similar to the discussion in the previous paragraph, the Company's interest
expense for the three months ended September
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30, 1998 decreased by comparison to the same period in 1997 primarily because of
lower interest rates and lower average outstanding borrowings on the Scrubgrass
Project working capital loan.
Income Tax Expense
Income tax expense for the three and nine months ended September 30,
1998 amounted to $308,000 and $29,000, respectively as compared to an income tax
expense of $674,000 for the three months ended September 30, 1997 and an income
tax benefit of $292,000 for the nine months ended September 30, 1997. The
fluctuations in income tax expense or benefit between 1998 and 1997 pertained
directly to fluctuations between the earnings or loss before taxes for such
periods. The effective tax rates for 1998 and 1997 are expected to be
comparable and may vary within 1% depending on the apportionment of income
between state taxing jurisdictions.
Outlook for the Remainder of 1998
With a view towards the remainder of 1998, the Company currently expects to
achieve earnings on an annual basis as a result of profits from Scrubgrass
project operations and management of corporate general and administrative
expenses. The Company offers the following prospective information concerning
significant components of its 1998 Consolidated Statement of Operations which
are being compared to historical results of operations in 1997:
Power generation revenues - Power generation revenues are expected to increase
in 1998 as a result of a 5% increase in certain contracted rates under the
Scrubgrass power purchase agreement and improvements in the expected annual
capacity rate for 1998. The Scrubgrass capacity rate, which was significantly
effected by the extended maintenance outage in 1997, is expected to improve in
1998 primarily because maintenance shutdowns are presently expected to occur to
a lesser extent during 1998. However, such increases in 1998 power generation
revenues are expected to be offset in part by a decrease in the revenue
recorded as a result of the straight-line accounting treatment of certain
revenues under the power purchase agreement. A favorable resolution of the
Company's legal action against Pennsylvania Electric Company could also have a
favorable impact upon power generation revenues. See "Part II - Item 1. Legal
Proceedings" and "-Certain Factors That May Impact Future Results-Legal
Proceedings" for a further discussion of the legal action against Pennsylvania
Electric Company.
Operating expenses - Operating expenses are expected to increase in 1998 as a
result of an approximate 3% increase in certain contracted rates under fuel
supply agreements, a 5% increase in certain contracted rates under the
operations and maintenance agreement and anticipated increases in personnel
costs at the Scrubgrass plant. In addition, largely because the Company is
anticipating that maintenance shutdowns will occur to a lesser extent during
1998, operating expenses are expected to further increase as a result of
additional fuel consumption and higher operator bonuses which are primarily
based on Scrubgrass operating profits. However, absent an extended outage in
1998, the Company would expect to incur lower maintenance expenses in 1998.
However, after performing certain machinery and equipment inspections during
the 1998 outage, the Company is now expecting to accelerate certain estimated
timeframes for completing maintenance in future years. The changes in these
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estimates are expected to increase maintenance reserves for the remainder of
1998 which would partially offset the savings in maintenance expense which
would otherwise have been realized from the absence of an extended outage in
1998. The Company also expects that certain improvements made in 1997 to its
fuel handling systems may offset a portion of the increases in fuel costs and
result in decreases in maintenance expenses during 1998.
Lease expenses - Lease expenses are expected to increase as a result of higher
scheduled principal payments on the Lessor's term loans which will increase the
Lessor's loan costs that are expected to be passed through to the Company in
its facility lease expenses. In addition, the Company expects to incur
scheduled increases in equity rents for the Scrubgrass Project in 1998.
However, largely due to required repayments of $1.2 million on the Company's $3
million credit facility and accelerated deposits to the maintenance reserve
fund, the Company expects that there would be less cash available from the
Scrubgrass Project during 1998. As such, the scheduled increases in the
aforementioned lease expenses are expected to be partially offset by a
reduction in the additional rent paid to the Lessor which amounts to 50 percent
of the net cash flows from the Scrubgrass Project (See the further discussion
under "--Liquidity and Capital Resources--Cash Flow Outlook"). The
aforementioned increases in 1998 lease expense are also expected to be offset
in part by decreases in the interest costs which would be passed through to the
Company in its facility lease expense and the lease expense which would be
recorded as a result of the straight-line accounting treatment of certain lease
expenses under the Scrubgrass lease.
General and administrative expenses - General and administrative expenses are
expected to increase in 1998 primarily because certain labor and overhead
expenses, which were capitalized in 1997 as a result of development activities
for the Milesburg project, will be redirected to operating activities during
1998. However, such increase is expected to be largely offset by decreases in
professional fees, certain management fees and insurance expenses during 1998.
Other revenue - In 1997, the Company enjoyed the benefit of certain non-
recurring revenues which included the gain on the sale of the Milesburg
project, the reversal of the provision for non-recovery of Milesburg project
development costs, interest earnings from proceeds on the sale of the Milesburg
project and revenue recorded as a result of the release of certain Milesburg
obligations which were payable only upon the occurrence of events related to
project development. The Company does not expect these items to recur in 1998.
RECENTLY ISSUED ACCOUNTING STANDARDS
See Note B to the Condensed Consolidated Financial Statements for a
discussion of accounting standards which the Company has adopted effective
January 1, 1998. There were no recently issued accounting standards since the
Company filed its Annual Report on Form 10-K for the year ended December 31,
1997 which would have any impact on the Company's financial statements.
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LIQUIDITY AND CAPITAL RESOURCES
Operating Activities
Cash used by operating activities amounted to $477,513 and $2,341,924 for
the nine months ended September 30, 1998 and 1997, respectively. During 1998 and
1997, the Company's only sources of cash from operating activities were
operating profits from the Scrubgrass Project and investment earnings from cash
reserves. The Company offers the following information to discuss the changes in
operating assets and liabilities which most notably impacted its cash position
during the nine months ended September 30, 1998:
Receivable from utility - The Company's receivable from utility relates to the
Scrubgrass Project and amounted to $6,223,922 as of September 30, 1998 as
compared to $6,538,645 as of December 31, 1997. The decrease in receivable
from utility as of September 30, 1998 is attributable to a decrease in revenues
during September 1998 and August 1998 by comparison to December 1997 and
November 1997 primarily as a result of unscheduled shutdowns. However, the
aforementioned decrease was offset in part by a 5% increase in certain rates
billed to the utility in 1998 under the terms of the Scrubgrass power purchase
agreement.
Other current assets - The Company's other current assets amounted to $784,804
as of September 30, 1998 as compared to $881,938 as of December 31, 1997. The
overall decrease is largely attributable a reduction in fuel inventory levels
which were higher than usual at December 31, 1997 because the Company had
advance purchased certain inventory during 1997 to obtain favorable pricing.
The aforementioned decrease was substantially offset by an increase in prepaid
insurance because the Company made a large prepayment when it renewed its
insurance policies during the second quarter of 1998.
Deferred income tax asset - The Company's deferred income tax asset amounted to
$1,073,755 as of September 30, 1998 as compared to $817,755 as of December 31,
1997. The increase is largely attributable to the recorded tax benefits of
expenses incurred during the nine months ended September 30, 1998 for financial
reporting purposes such as maintenance reserves which will be deductible for
tax reporting purposes in future years.
Accounts payable and accrued expenses - The Company's accounts payable and
accrued expenses amounted to $5,524,720 as of September 30, 1998 as compared to
$6,325,062 as of December 31, 1997. The overall decrease is largely
attributable to the following two factors. First, the Company had significant
accruals for corporate income taxes and additional rent as of December 31, 1997
which either did not exist or existed to a lesser extent as of September 30,
1998. Second, due to a decrease in the capacity rate during the third quarter
of 1998 by comparison to the fourth quarter of 1997, the liabilities for
certain variable expenses existed to a lesser extent as of September 30, 1998
when compared to December 31, 1997. The aforementioned decreases in accounts
payable and accrued expenses were offset in part by the following two factors.
First, the Company incurred additional maintenance expenses for unscheduled
outages during the third quarter of 1998 that increased its accounts payable
and accrued expenses as of September 30, 1998 when compared to December 31,
1997. Second, as discussed in the section "Results of Operations", the Company
has
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seen expected increases in certain 1998 expenses by comparison to 1997 which
resulted in higher accounts payable and accrued expenses balances as of
September 30, 1998 by comparison to December 31, 1997.
Deferred gain, net - The Company's deferred gain, net amounted to $5,474,290 as
of September 30, 1998 as compared to $5,705,598 as of December 31, 1997. The
decline is due to the amortization of the deferred gain related to the
Scrubgrass Project, which is being amortized on a straight-line basis over 22
years.
Maintenance reserve - The Company records the expense of major equipment
overhauls related to the Scrubgrass Project to a maintenance reserve on a
straight-line basis using management's best estimate of when the Company will
incur future cash outlays for the major equipment overhauls. When the Company
incurs cash outlays for major equipment overhauls, they reduce maintenance
reserves and are funded substantially from scheduled deposits to a restricted
major maintenance fund which have been set aside to ensure that the funds are
available for these maintenance procedures (see further discussion under the
caption "--Investing Activities-Restricted Cash"). The maintenance reserve
increased to $2,120,900 as of September 30, 1998 from $1,995,818 as of December
31, 1997 primarily due to scheduled reserves provided for the ongoing
maintenance of the plant. The increase was offset in part by cash outlays for
major equipment overhauls made during the 1998 Scrubgrass outage and because
certain modifications to the financing contract with the manufacturer of the
Scrubgrass generator reduced long-term liabilities included in the maintenance
reserve. For a further discussion of the modifications to the financing
contract with the manufacturer of the Scrubgrass generator, refer to the
section "--Liquidity and Capital Resources--Cash Flow Outlook".
Investing Activities
The Company used $188,464 and $712,738 in investing activities during the
nine months ended September 30, 1998 and September 30, 1997, respectively. The
Company's investing activities are concentrated primarily in the following
areas:
Notes receivable - The Company presently has notes receivable related to the
1994 sale of the Sunnyside Project and related to fees earned in 1995 for the
Scrubgrass Project. The Company collected $29,052 and $26,825 from notes
receivable related to the Scrubgrass Project during the nine months ended
September 30, 1998 and September 30, 1997, respectively. The notes receivable
related to the Sunnyside Project, with a principal balance of $2,937,500 and
accrued interest balance of $735,380 as of September 30, 1998, are the subject
of a legal proceeding. See "--Certain Factors That May Impact Future Results-
Legal Proceedings" and "Part II - Item 1. Legal Proceedings" for further
information about the notes receivable related to the Sunnyside Project.
Restricted cash - The Company is presently required to make scheduled deposits
to a restricted major maintenance fund relating to the Scrubgrass Project to
ensure that funds are available in the future for scheduled major equipment
overhauls. The Company is also allowed to spend restricted cash to fund the
cost of major equipment overhauls subject to certain restrictions. During the
nine months ended September 30, 1998, the Company's net deposits to the
restricted major maintenance fund and interest thereon exceeded its payments
for major equipment overhauls by
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<PAGE>
$212,319 while the Company's payments for major equipment overhauls exceeded
its net deposits to the restricted major maintenance fund by $313,256 during
the nine months ended September 30, 1997. The Company's expenditures for major
equipment overhauls were significantly higher during the 1997 extended outage
by comparison to the 1998 outage. For this reason, the Company's expenditures
for major equipment overhauls exceeded its scheduled deposits to the restricted
major maintenance fund during the nine months ended September 30, 1997.
Property plant and equipment - The Company invested $5,197 and $1,052,819 in
property, plant and equipment expenditures during the nine months ended
September 30, 1998 and September 30, 1997, respectively. The expenditures in
1997 were primarily related to development activities for the Company's
Milesburg Project which was sold in December 1997 and for which development
efforts had increased in 1997 prior to the sale. The expenditures in 1998 were
primarily purchases of computer equipment for the Company's corporate office.
Financing Activities
The Company utilized $11,059,930 in financing activities during the nine
months ended September 30, 1998 and received $2,347,577 from financing
activities during the nine months ended September 30, 1997. The Company's
financing activities are concentrated primarily in the following areas:
Dividends - The Company has a quarterly dividend program which is subject to
review and consideration by the Board of Directors each quarter. In respect of
this dividend program, other than special dividends declared from time to time,
the Company declared dividends of 3 cents per share during each of the quarters
in the nine month period ending September 30, 1997, 3 cents per share during
each of the quarters in the six month period ending June 30, 1998 and 1.5 cents
per share during the quarter ending September 30, 1998. As of December 31,
1997, the Company had dividends payable for common stock of $10,266,105 or 90
cents per share (consisting of a 3 cent quarterly dividend and an 87 cent
special dividend out of the proceeds of the Milesburg buy-out) which were
declared on December 10, 1997 and paid on January 7, 1998. The Company also had
dividends payable for common stock as of September 30, 1998 of $171,102 or 1.5
cents per share which were declared on September 22, 1998 and paid on October
9, 1998. As such, dividends paid for common stock amounted to $10,950,512 and
$999,760 during the nine months ended September 30, 1998 and September 30,
1997, respectively. During 1997, the Company also commenced the payment of
dividends to its subsidiary's preferred stockholder. The preferred stockholder,
entitled to cumulative dividends of $5,000 per year since December 1991, was
paid its dividends up to date in April 1997. The Company paid dividends to its
subsidiary's preferred stockholder of $3,750 and $28,928 during the nine months
ended September 30, 1998 and September 30, 1997.
Working Capital Loan - The Company may borrow up to $4 million under a Lessee
Working Capital Loan Agreement with the Lessor for ongoing working capital
requirements of the Scrubgrass Project. During the nine months ended September
30, 1998, the Company increased its outstanding borrowings under the Lessee
Working Capital Loan Agreement from $2,311,666 as of December 31,
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<PAGE>
1997 to $2,805,998 as of September 30, 1998. The increase in the working
capital loan as of September 30, 1998 was primarily used to cover the cash
deficiency which resulted from reduced revenues during the second and third
quarters as a result of scheduled and unscheduled shutdowns at the Scrubgrass
plant. This increase in the working capital loan tends to be seasonal and
occur shortly after the scheduled maintenance outage each year. However,
because the Scrubgrass plant incurred several unscheduled shutdowns for
equipment repairs during the third quarter of 1998, the balance of working
capital loan remains at a higher level as of September 30, 1998.
Term Credit Facility - In June 1997, the Lessor entered into a three year
credit facility with the lenders of the Scrubgrass Project to make additional
funds available to the Scrubgrass Project to cover the cash deficiency which
resulted from the extended annual outage to repair the generator and associated
costs and expenses. The maximum allowable borrowings under this credit
facility were $3,000,000 through July 1, 1998 at which time the maximum
allowable borrowings were reduced to $2,400,000. Beginning on January 4,
1999, the maximum allowable borrowings will continue to reduce in $600,000
increments every six months through July 3, 2000 when the credit facility will
be payable in full. As of December 31, 1997, the outstanding borrowings under
this credit facility, which were advanced to the Company by the Lessor,
amounted to $3,000,000. During the nine months ended September 30, 1998, the
Company paid down this obligation by $600,000 in order to reduce this
obligation to the maximum allowable borrowing amount of $2,400,000 which became
effective on July 1, 1998. The current portion of this obligation, which
amounted to $1,200,000 as of September 30, 1998, is included in other current
liabilities.
Notes payable - In addition to the term credit facility described previously,
the Company has other long-term obligations related to its Sunnyside Project
and Scrubgrass Project in the amounts of $1,014,435 and $1,267,811,
respectively as of September 30, 1998. The Sunnyside Project long-term
obligations are payable based on a schedule which relates directly to the
amount of proceeds received from the collection of the outstanding notes
receivable from the sale of the Company's interest in the Sunnyside Project,
which notes are currently the subject of a legal proceeding (See "--Certain
Factors That May Impact Future Results--Legal Proceedings" and "Part II - Item
1. Legal Proceedings"). The next installment for the Scrubgrass Project long-
term obligation amounts to $39,585 and is payable later in 1998.
Cash Flow Outlook
During 1998, the Company expects that its principal sources of cash to fund
its business activities will be from available cash balances, investment
earnings and cash which may become available from the Scrubgrass Project. As
discussed more fully in the Company's 1997 Annual Report on Form 10-K, the
Company is not able to receive cash from the Scrubgrass Project until all
operating expenses, base lease payments (which include the Lessor's debt
service), certain maintenance reserve payments and other subordinated payments
of the Scrubgrass Project are first satisfied.
As discussed under the caption "--Results of Operations--1998 Outlook", the
Company expects that the Scrubgrass Project will be profitable in 1998 and will
generate cash flows from its operating activities. However, the Company
anticipates that a significant portion of the expected
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cash flows in 1998 will be utilized for debt and maintenance reserve repayments.
According to the terms of certain Scrubgrass Project obligations, the Company
will be required to pay down the $3 million term credit facility to $1,800,000
by January 4, 1999 and make an installment payment later in 1998 of $39,585
under the $1.3 million Scrubgrass Project note. Furthermore, the Company is
expecting to make deposits to the major maintenance reserve fund which are in
excess of normal requirements through April 1999 to ensure that sufficient funds
are available for major overhauls which are expected to be performed during the
1999 planned annual outage at Scrubgrass. However, as discussed more fully in
the Company's 1997 Annual Report on Form 10-K, the Company is required to pay
the Lessor, in addition to a specified base rent, an additional rent of 50
percent of the net cash flows it receives from the Scrubgrass Project.
Therefore, the Company would expect to realize a savings in its additional rent
expense to the extent of 50 percent of any required debt and maintenance reserve
repayments. As such, the Company expects that the cash flows which may become
available in 1998 from the Scrubgrass Project would only be reduced by 50
percent of any required debt and maintenance reserve repayments.
In September 1998, the Company filed its 1997 corporate income tax returns
which clarified its corporate income tax position. Prior to 1997, the Company
had substantial net operating loss carryforwards which sheltered the Company
from paying Federal and certain state corporate income taxes in those years.
However, primarily as a result of the 1997 Milesburg project sale, the Company
had substantial taxable income in 1997 which utilized all of the Company's
previous net operating loss carryforwards. As such, for tax years beginning in
1997, the Company expects to owe significant corporate Federal and state income
taxes. Earlier in 1998, the Company made certain estimates of taxes which would
be owed for tax year 1998. However, based on information gathered during the
process of completing the 1997 corporate income tax returns, the Company's
income tax estimates for 1998 were slightly increased.
As discussed in a previous filing, the Company improved its financial
position by revising the terms of its installment contract to finance the 1997
repair of the Scrubgrass generator. Under the terms of the revised agreement
with the manufacturer of the Scrubgrass generator ("GEC"), as payment in full
for their recent work performed during the 1998 outage and for the five
remaining installments of $110,000 and $75,000 bonus owed under the original
contract, the Company will pay GEC a total of $450,000 over a four year period.
The revised agreement provides that $50,000 was payable upon the completion of
their work during the scheduled 1998 plant outage and that $100,000 is payable
upon each of the first four anniversaries of the first payment thereof. As of
September 30, 1998, the initial payment of $50,000 has been paid and the Company
has recorded in its Consolidated Balance Sheet the present value of the
remaining four installments, discounted at the Scrubgrass Project's incremental
borrowing rate (6.75%), which amounted to approximately $364,000, in its
maintenance reserve. During the first quarter in 1998, the Company recognized,
through a reduction of its operating expenses, the reduction of the present
value of the future installments due to GEC, which reduction amounted to
approximately $169,000 as of December 31, 1997.
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The Company is optimistic about the future performance of the Scrubgrass
Project which is currently expected to achieve earnings on an annual basis for
the foreseeable future. The Scrubgrass power purchase agreement has contracted
rate escalations which, assuming the Scrubgrass project meets its targeted
capacity rates, would ensure a material increase in revenues in future years.
Furthermore, as discussed in "Part II. Other Information - Item 1. Legal
Proceedings", the Company is involved in discussions with PENELEC to settle the
ongoing litigation. A settlement of the litigation with PENELEC could further
enhance future revenues and could result in a material settlement for the
Company's claims that the Scrubgrass Project is owed contract rates for previous
power generation supplied in excess of 80 MW. Notwithstanding, the Scrubgrass
Project will obviously bear the burden of repaying the debt obligations relating
to the extended outage of the Scrubgrass Project in the near term. Nevertheless,
the Company believes that the cash flows which may become available from the
Scrubgrass Project, together with cash reserves which the Company estimates were
approximately $300,000 at September 30, 1998, would be sufficient to fund the
Company's business activities on a long-term basis. However, the payment of any
future dividends will depend on the Board of Directors' evaluation, made on a
quarterly basis, based on their dividend policy and the Company's then current
and projected operating performance and capital requirements. See the further
discussions under "--Dividend Program" and "--Certain Factors That May Affect
Future Results" below.
Dividend Program
The Company has a quarterly dividend program which is subject to review and
consideration by the Board of Directors each quarter. In respect of this
dividend program, in addition to special dividends which have been declared from
time to time, the Company has historically declared dividends of 3 cents per
share during each of the last ten quarters through June 30, 1998. However,
during the quarter ended September 30, 1998, the Company reduced its dividend to
1.5 cents per share. The recent change in dividend amount reflects the
Company's policy of seeking to distribute the maximum funds available each
quarter to shareholders. The maximum funds available for distribution is
determined by the Board each quarter and represents the amount the Company does
not expect it will need for ongoing operations and any planned projects assuming
expected operating results are achieved. In addition, the Board considers the
level of reserves and determines what is reasonable as a buffer against
surprises, variations from expectations and reasonable contingencies in the
upcoming periods. Behind all of these considerations is the philosophy that the
Company should not be holding reserves that it does not expect are reasonably
needed for continuing operations and contingencies. Historically, the Company
has not operated using a philosophy of holding reserves for future dividends
since such a philosophy would represent the Company's "investment" of its
shareholder's money which would be given out later if the Company was not
generating sufficient cash at that time to continue the dividend. The Board's
position has been that the Company's shareholders acquired their shares in the
Company for its management of power generation facilities and that shareholders
would be better served investing for themselves the money that the Company can
distribute.
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The "downside" of the Company's philosophy of seeking to distribute the
maximum funds available each quarter to shareholders is the risk that dividends
need to be reduced when cash flow is reduced and/or projected expenses and
contingencies are greater than foreseen. That risk became a reality in the third
quarter of 1998 when operating results were not as strong as anticipated
primarily due to unscheduled outages for repairs. This followed unplanned
maintenance outages in the second quarter which had weakened the Company's
opening cash position for the third quarter. Furthermore, as discussed under the
section "--Cash Flow Outlook", the Company recently increased its forecasted
cash requirements for major maintenance at the Scrubgrass project and for
corporate income taxes. These increases placed further restrictions on the
Company's available cash flows in the near term.
While the Company has been recently experiencing cash flow restraints, the
Company currently expects that these cash flow restraints are temporary. As
discussed in the Section "--Cash Flow Outlook", the Company currently expects
the Scrubgrass project will realize contracted increases in revenue and be
profitable in future years. In addition, as discussed in "Part II. Other
Information. - Part 1. Legal Proceedings", the Company is involved in
discussions with PENELEC to settle the ongoing litigation which could further
enhance future revenues and cash flows. In keeping with the Company's current
policy of seeking to distribute the maximum funds available each quarter to
shareholders, the Company presently expects that its Board would continue to
authorize dividends in the future as cash becomes available. However, there can
be no assurance that cash will become available in the future, that the Company
will make dividends to shareholders in the future or that dividends, if
declared, would remain consistent from period to period.
Year 2000 Readiness
GENERAL
The Company continues to address the issue of Year 2000 Readiness ("the Y2K
Project") and is proceeding on a schedule designed to complete the Y2K Project
by June 1999. In 1997, the Company began establishing procedures to assess the
risks associated with the Y2K Project. The Company's procedures to assess the
risks of the Y2K Project have included an inventory of stand-alone hardware and
software ("IT Systems"), an inventory of all system components embedded in the
Scrubgrass plant operating control systems ("Non-IT Systems"), the
identification of critical vendors, customers and business partners, the testing
of both IT Systems and Non-IT systems and a solicitation of responses from all
critical vendors, customers and business partners indicating their readiness for
the Year 2000.
Presently, the Company has completed its testing of IT Systems and Non-IT
Systems. Based on the results of these tests, the Company has identified IT
Systems and components of Non-IT Systems which are not Year 2000 compliant.
With respect to IT systems, the Company has either already upgraded such systems
or has placed orders to upgrade such systems in the near future. As far as Non-
IT Systems, the Company is presently awaiting the recommendations of third
parties regarding solutions to either upgrade or replace non-compliant system
components. At this time, the Company has received assurances from such third
parties that solutions to
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remedy the non compliant system components are readily available and could be
implemented within the Company's time parameters for the Y2K Project.
The Company has made substantial progress in securing responses from most
critical vendors and business partners indicating their readiness for Year 2000.
Based on the responses received to date, the Company has not identified any
conditions of potential non-compliance which the Company estimates would
materially impact its business.
COSTS
The Company does not expect that the total costs to remediate Year 2000
issues would be material to its financial position. The Company has incurred
cumulative costs to remediate Year 2000 issues of approximately $61,000 through
September 30, 1998. The Company estimates that it will incur additional costs
of approximately $127,000 to remediate Year 2000 issues. The Company expects to
fund such costs from its operating cash flows.
RISKS AND CONTINGENCY PLANS
The Company believes that it has established a viable plan designed to ensure
that the Y2K Project is completed prior to the year 2000. However, in
connection with its Y2K Project, the Company is also developing a contingency
plan which describes the steps the Company would take if the Y2K Project is not
completed as planned. The Y2K Project efforts are ongoing and the Company will
endeavor to update the Y2K Project activities and its contingency plans as new
information becomes available.
The Year 2000 problem is a world-wide concern and there is a tremendous
amount of uncertainty about the effect this problem will have on any business.
The Company is endeavoring to understand the impact that failures of third
parties could have on its business. However, even with a diligent effort, the
Company may not be able to conceive every scenario in which a third party
failure could impact its business. However, through direct solicitation, the
Company has taken steps to assess the risk that known third parties with whom it
has significant business relationships are sufficiently prepared for the Year
2000.
The Company has key relationships with numerous vendors and business
partners. Presently, the Company has received responses from most key vendors
and business partners indicating their readiness for the Year 2000. Based on
the responses received to date, the Company has not identified any conditions of
potential non-compliance which the Company estimates would materially impact its
business. The Company has considered its relationships with the vendors and
business partners who have not yet indicated their readiness for Year 2000.
Based on this review, the Company does not believe that its business would be
materially effected if any of these vendors or key business partners failed to
ensure that they were Year 2000 compliant.
The Company has one customer, PENELEC, a public utility which is
contractually obligated to purchase all of the power supplied by the Scrubgrass
facility. While the Company believes that PENELEC is taking the appropriate
steps to ensure that it is ready for the Year 2000, the
21
<PAGE>
Company has received no formal correspondence which indicates that PENELEC
expects to be ready. While the computer systems at Scrubgrass are not directly
connected to those at PENELEC, it is conceivable that the Company could still
experience business interruptions if PENELEC fails to ensure that its systems
are Year 2000 compliant. Because the Company is dependent on this one customer,
any business interruptions could have a material impact on the Company's
financial position and results of operations.
The Company has taken steps it deems prudent to understand its Year 2000
risks, to estimate the costs to complete its Y2K Project and to understand the
extent to which it could be impacted by third parties who fail to ensure they
are ready for the Year 2000. However, there can be no assurance that all non-
compliant systems or system components will be identified, that the Company's
systems will be Year 2000 compliant, that the Company will achieve its estimated
remediation costs or timetable, or that a failure by a third party to be Year
2000 compliant would not have a material adverse affect on the Company's
business. However, by completing its Y2K Project, the Company believes it will
have taken appropriate steps to mitigate the risk that any of the aforementioned
items would have a material adverse affect on its business.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
The following important factors, among others, could cause actual results
to differ materially from those indicated by forward-looking statements made in
this Quarterly Report on Form 10-Q.
Ownership of Single Operating Asset
The Company owns a 22 year leasehold interest in the Scrubgrass Project, an
approximate 83 Mw (net) waste-coal fired electric generating facility located in
Pennsylvania, the lease for which commenced on June 30, 1994. Presently, all
the Company's operating revenues are attributable to power generation from the
Scrubgrass Project. Accordingly, the Company's operations are largely dependent
upon the successful and continued operation of the Scrubgrass Project. In
particular, if the Scrubgrass Project experiences unscheduled shutdowns of
significant duration, the Company's results of operations will be materially
adversely affected.
Dependence Upon Key Employees
The success of the Company is largely dependent upon a staff of four full-
time employees and one part-time employee, including three executive officers.
The loss of any of these employees could adversely effect the Company's
operations.
Third Party Project Management
The Company has entered into a management services agreement with U.S. Gen
to manage the Scrubgrass Project and a 15-year operations and maintenance
agreement with U.S. Operating Services to operate the facility. Under the terms
of these agreements, there are provisions which limit the Company's
participation in the management and operation of the
22
<PAGE>
Scrubgrass Project, and provisions which provide for recourse against the
manager and operator for unsatisfactory performance. However, the Company does
not exercise control over the operation or management of the Scrubgrass Project.
As such, decisions may be made affecting the Scrubgrass Project, notwithstanding
the Company's opposition, which may have an adverse effect on the Company.
Scheduled and Unscheduled Shutdowns
The Scrubgrass Project from time to time experiences both scheduled and
unscheduled shutdowns. Periodically, the Scrubgrass Project incurs scheduled
shutdowns in order to perform maintenance procedures to equipment that cannot be
performed while the equipment is operating. Occasionally, the Scrubgrass Project
may also incur unscheduled shutdowns or may be required to operate at reduced
capacity levels following the detection of equipment malfunctions, or following
minimum generation orders received by the utility. During periods when the
Scrubgrass Project is shutdown or operating at reduced capacity levels, the
Company may incur losses due to the loss of its operating revenues and/or due to
additional costs which may be required to complete any maintenance procedures.
It is not possible for the Company to predict the frequency of future
unscheduled shutdowns or to predict the extent of maintenance which may be
required during shutdowns related to equipment maintenance.
Legal Proceedings
As discussed under the caption "Part II. Item 1.-Legal Proceedings", the
Company is involved in a legal proceeding with the purchasers of the Company's
interest in the Sunnyside Project which was sold in 1994. Pending the
resolution of the legal proceeding, the purchasers have withheld scheduled
payments of principal and interest due on the promissory notes since June 1996,
which amounted to $2,937,500 and $735,380, respectively as of September 30,
1998. In addition, the Company recorded in 1994 a receivable related to a
purchase price adjustment, as provided for in the Purchase and Sale Agreement,
of approximately $1.1 million, of which $708,000 was received in April 1995.
The balance of purchase price adjustment is also being disputed in the legal
proceeding with the purchasers. Although the Company's available cash and cash
provided by operating activities has been sufficient to fund the Company's
investing and financing activities, the withholding of scheduled principal and
interest payments has adversely affected the Company's cash flow. At this time,
while management believes the Company's position in this litigation is
meritorious, the Company cannot predict whether it will prevail in the
litigation and to what extent it will incur professional fees to defend its
position in the litigation. An unfavorable resolution and/or extensive
professional fees to defend the litigation could adversely affect the Company's
results of operations.
As discussed under the caption "Part II. Item 1.-Legal Proceedings", the
Company is also a plaintiff in a legal proceeding with Pennsylvania Electric
Company ("PENELEC"), the utility which purchases electricity from the Scrubgrass
facility. In this legal proceeding, among other complaints, the Company alleged
that PENELEC has breached the power purchase agreement by failing to pay
contract rates for energy produced by the Scrubgrass facility in excess of 80 MW
in any hour. At this time, while management believes the Company's position in
this litigation is
23
<PAGE>
meritorious, the Company cannot predict whether it will prevail in the
litigation and receive contract rates for energy produced by the Scrubgrass
facility in excess of 80 MW in any hour.
Financial Results
To date the Company has incurred substantial losses, primarily due to its
development activities, which have resulted in an accumulated deficit of
$3,540,183 as of September 30, 1998. While the Company was profitable overall
during 1997, the Company incurred a loss from the operation of the Scrubgrass
Project during 1997 due to an unforeseen repair to the generator at the
Scrubgrass facility. While the Company continues to expect to be profitable for
1998, the Company's 1998 results to date have been adversely affected by several
unscheduled shutdowns during the second and third quarters resulting from
equipment malfunctions. Financial results can be affected by numerous factors,
including without limitation general economic conditions, cyclical industry
conditions, the amount and rate of growth of expenses, transportation and
quality of raw materials, inflation, levels of energy rates, uncertainties
relating to government and regulatory policies, the legal environment, and the
occurrence of unpredictable events like the generator repair and the equipment
malfunctions. The Company believes it is well positioned to handle such matters
as they may arise during the course of its future business activities. However,
there can be no assurance that the Company will be profitable in the future.
Development Uncertainties
From time to time, the Company invests its resources to develop power
generating facilities or invest in other projects of a development nature. The
successful development of power generating facilities or similar projects
typically require the Company to obtain all of the necessary site agreements,
fuel supply contracts, design/build agreements, power sales contracts, licenses,
environmental and other permits, local government approvals or financing
commitments required to complete such projects. However, the failure to
accomplish any of the aforementioned steps could materially increase the cost or
prevent the successful completion of projects under development, or cause the
Company to abandon the pursuit of such development projects and incur the loss
of its investment to date, which could materially impact the Company's business
and results of operations. As of September 30, 1998, the Company has no
projects which are in the development stage.
Potential Liability, Damages and Insurance
The Company's power generation activities involve significant risks to the
Company for environmental damage, equipment damage and failures, personal injury
and fines and costs imposed by regulatory agencies. In the event a liability
claim is made against the Company, or if there is an extended outage or
equipment failure or damage at the Company's power plant for which it is
inadequately insured or subject to a coverage exclusion, and the Company is
unable to defend such claim successfully or obtain indemnification or warranty
recoveries, there may be a material adverse effect on the Company.
24
<PAGE>
Year 2000
The Company faces risks and uncertainties relating to the Year 2000 problem
which are described under "--Year 2000 Readiness" above.
Circulating Fluidized Bed Technology
The Company's Scrubgrass Project employs circulating fluidized bed
technology to produce electricity. Certain aspects of this technology, as well
as the conversion of waste products into electricity, are relatively new areas
being explored by the alternative energy market in the last ten years.
Accordingly, this technology carries greater risk than more established methods
of power generation such as hydropower. As such, the long-term costs and
implications of maintaining this technology have not been established by
historical industry data.
Customer Concentration
The Company's power generation revenues are earned under a long-term power
purchase agreement with one customer, Pennsylvania Electric Company. The
Company expects that the concentration of its revenues with this customer will
continue for the foreseeable future.
Interest Rates
The Company's subsidiary, as a lease cost of the Scrubgrass facility, is
required to fund the Lessor's debt service which primarily consists of $135.6
million of variable rate tax-exempt bonds maturing through 2012, a $17.1 million
remaining term loan maturing through 2005, a $10.7 million variable rate term
loan maturing through 2004 and $0.4 million in remaining junior subordinated
debt obligations which mature through 1999. The Company's subsidiary is also
required to fund a variable rate working capital loan, a $1.3 million variable
rate term loan maturing through 2004 and $2.4 million in advances from the
Lessor under a variable rate credit agreement executed in June 1997. The Lessor
entered into interest rate swaps which had the effect of fixing the interest
rate on the tax-exempt bonds until May 18, 1996 at approximately 3.72% and
fixing the interest rate over the life of the $17.1 million remaining term loan
at 6.42%. After May 18, 1996, the Company's specified base rent was incurred
based on floating rates on the Lessor's tax-exempt bonds. As such, except for
the Lessor's $17.1 million remaining term loan and $0.4 million remaining junior
subordinated debt obligations, the Company will be required to fund debt service
consisting of rates which will vary with market conditions. Presently, the
Company is not able to predict how future interest rates will affect its lease
expense or debt service. Should market interest rates rise significantly, the
Company's operating results may be significantly impacted. Notwithstanding, the
Company believes the Lessor has good relationships with the project lenders who
would continue to support lending terms which would not have a material adverse
affect on the operating results of the Scrubgrass Project. However, there can
be no assurance that the Lessor could renegotiate its credit facilities under
terms which would ensure continuing profitable operating results of the
Scrubgrass Project.
25
<PAGE>
Fuel Quality
The Company obtains waste coal primarily from coal mining companies on a long-
term basis because waste coal is plentiful and generally creates environmental
hazards, such as acid drainage, when not disposed of properly. The waste coal
is burned in the Scrubgrass facility using a circulating fluidized bed
combustion system. During the circulating fluidized bed combustion process, the
waste coal is treated with other substances such as limestone. Depending on the
quality of the waste coal, the facility operator may need to add additional
waste coal or other substances to create the appropriate balance of substances
which would result in the best fuel or sorbent consistency for power generation
and compliance with air quality standards. Therefore, the cost of generating
power is directly impacted by the quality of the waste coal which supplies the
Scrubgrass power generation facility. The facility operator maintains certain
controls over obtaining higher quality waste coal. However certain conditions,
such as poor weather, can create situations where the facility operator has less
control over the quality of the waste coal. The Company cannot predict the
extent to which poor fuel quality may impact its future operating results.
Competition
The Company generates electricity using alternative energy sources which is
sold on a wholesale basis under long-term contracts to utilities under rates
established in power purchase agreements and approved by regulatory agencies.
The independent power industry has grown rapidly over the past twenty years.
There are a large number of suppliers in the wholesale market and a surplus of
capacity which has led to intense competition in this market. The principal
sources of competition in this market include traditional regulated utilities
who have excess capacity, unregulated subsidiaries of regulated utilities,
energy brokers and traders, energy service companies in the development and
operation of energy-producing projects and the marketing of electric energy,
equipment suppliers and other non-utility generators like the Company.
Competition in this industry is substantially based on price. The electric
industry is also characterized by rapid changes in regulations which the Company
expects could continue to increase competition. For instance, as discussed more
fully in the Company's latest Annual Report on Form 10-K, the electric industry
has been previously affected by legislation such as the Federal Public Utility
Regulatory Policies Act of 1978 ("PURPA") and the Energy Policy Act of 1992
("Energy Act") which have encouraged companies other than utilities to enter the
electric power business by reducing regulatory constraints. More recently, as
discussed under the caption "--Energy Regulation" below, there has been new
state legislation to deregulate the generation component of the electric
business. Furthermore, as discussed under the caption "Energy Regulation",
proposed changes to repeal or modify the Public Utility Holding Company Act of
1935 ("PUHCA") and PURPA could reduce regulatory restrictions placed on electric
utilities and encourage them to seek new sources of electric power. Any of
these regulatory matters, among others, could increase competition for electric
power. Other than the risk that PENELEC will seek to renegotiate the terms of
the Scrubgrass power purchase agreement (see further discussion under the
caption "Energy Regulation"), the Company does not believe it will be
significantly impacted by competition in the wholesale energy market since its
revenues are subject to contracted rates which are substantially fixed for
several years. However, the contracted rates in
26
<PAGE>
the later years of the Scrubgrass power purchase agreement switch to rates which
vary more closely with existing market conditions. Should ensuing competition
in the later years of the Scrubgrass power purchase agreement create downward
pressure on wholesale energy rates, the Company's profitability could be
impacted.
The Company also competes in the market to develop power generation
facilities. The primary bases of competition in this market are the quality of
development plans, the ability of the developer to finance and complete the
project and the price. In certain cases, competitive bidding for a development
opportunity is required. Competition for attractive development opportunities
is expected to be intense as there are a number of competitors in the industry
interested in the limited number of such opportunities. Many of the companies
competing in this market have substantially greater resources than the Company.
The Company believes its project development experience and its experience in
creating strategic alliances with other development firms with greater financial
and technical resources could enable it to continue to compete effectively in
the development market when opportunities arise. Presently, the Company believes
there are limited opportunities for additional project development in the United
States for projects similar to those previously developed by the Company.
Presently, there is significant merger and consolidation activity occurring
in the electric industry. From time to time, the Company considers sale or
merger strategies and proposals when they appear to present an opportunity to
enhance shareholder value.
Energy Regulation
The Company's projects are subject to regulation under federal and state
energy laws and regulations. The Company's facilities are either self-certified
as a Qualifying Facility under PURPA, or formally certified as a Qualifying
Facility by the Federal Energy Regulatory Commission ("FERC"). Pursuant to
PURPA, FERC has promulgated regulations which exempt certain Qualifying
Facilities from the Federal Power Act of 1920, PUHCA, and, except under certain
limited circumstances, state laws regulating the rates charged by electric
utilities. In order to qualify under PURPA, the Company's facilities must meet
certain size, fuel and ownership requirements and/or co-generate. In addition
to the regulation of Qualifying Facilities, PURPA requires that electric
utilities purchase electric energy produced by qualifying facilities at
negotiated rates or at a price equal to the incremental or avoided cost that
would have been incurred by the utility if it were to generate the power itself
or purchase it from another source. The Company is not presently subject to
regulation under PUHCA and does not presently intend to engage in any activities
that would cause it to be so regulated.
The Company believes that changes in PURPA, PUHCA and other related federal
statutes could occur in the next several years. The nature and impact of such
changes on the Company's projects is unknown at this time. Presently, there are
several legislative proposals pending in Congress which propose amendments to
certain regulations promulgated by PURPA. If Congress amends PURPA, the
statutory requirement that electric utilities purchase electricity from
Qualifying Facilities at full avoided cost could be repealed or modified. While
current legislative proposals specify the honoring of existing contracts, the
repeal or modification of these statutory
27
<PAGE>
purchase requirements under PURPA in the future could increase pressure for
electric utilities to renegotiate existing contracts. Should there be changes
in statutory purchase requirements under PURPA, and should these changes result
in amendments which reduce the contracted rates under the Scrubgrass power
purchase agreement, the Company's results of operations and financial position
could be negatively impacted.
State public utility commissions, pursuant to state legislative authority,
may have jurisdiction over how any new federal initiatives are implemented in
each state. Although FERC generally has exclusive jurisdiction over the rates
charged by an independent power project to its wholesale customers, state public
utility commissions have the practical ability to influence the establishment of
such rates by asserting jurisdiction over the purchasing utility's ability to
pass through the resulting cost of purchased power to its retail customers. In
addition, although thought to be unlikely, states may assert jurisdiction over
the siting and construction of independent power projects and, among other
things, the issuance of securities and the sale and transfer of assets. The
actual scope of jurisdiction over independent power projects by state public
utility regulatory commissions varies from state to state. Presently, through
its power purchase agreement with PENELEC, the Scrubgrass Project is indirectly
subject to state legislation in the Commonwealth of Pennsylvania.
In recent years, in response to changes in the electric industry, the
Commonwealth of Pennsylvania has passed new legislation most notably in the area
of deregulating the generation portion of the electric business. On December 3,
1996, the Commonwealth of Pennsylvania passed new legislation known as the
Electricity Generation Customer Choice and Competition Act (Customer Choice Act)
which became effective on January 1, 1997. The Customer Choice Act permits all
Pennsylvania retail electric customers to choose their electric generation
supplier over a phase-in period which expires December 31, 2000. The Customer
Choice Act has required that all electric utilities file restructuring plans
with the Pennsylvania Public Utility Commission which, among other things,
included unbundled prices for electric generation, transmission and distribution
and a competitive transition charge ("CTC") for the recovery of "stranded costs"
which would be paid by all customers receiving distribution service and certain
customers that increase their own generation of electricity. "Stranded costs"
generally are electric generation-related costs that traditionally would be
recoverable in a regulated environment but may not be recoverable in a
competitive electric generation market.
Presently, none of the new or proposed legislation directly impacts the
Company since the legislation pertains to the retail market or new contracts in
the wholesale market. However, as discussed previously, the Company could be
impacted in the future by, among other things, increases in competition as a
result of deregulation, or increasing pressure on electric utilities to
renegotiate existing power contracts. The Company is actively monitoring these
developments in energy proceedings in order to evaluate the impact on its
projects and also to evaluate new business opportunities created by the
restructuring of the electric industry.
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<PAGE>
Environmental Regulation
The Company's projects are subject to regulation under federal, state and
local environmental and mining laws and regulations and must also comply with
the applicable federal, state and local laws pertaining to the protection of the
environment, primarily in the areas of water and air pollution. These laws and
regulations in many cases require a lengthy and complex process of obtaining and
maintaining licenses, permits and approvals from federal, state and local
agencies. As regulations are enacted or adopted in any of these jurisdictions,
the Company cannot predict the effect of compliance therewith on its business.
The Company's failure to comply with all applicable requirements could result in
delays in proceeding with any projects under development or require
modifications to operating facilities. During periods of non-compliance, the
Company's operating facilities may be forced to shutdown until the non-
compliances are corrected. The Company is responsible for ensuring compliance
of its facilities with all applicable requirements and, accordingly, attempts to
minimize these risks by dealing with reputable contractors and using appropriate
technology to measure compliance with the applicable standards.
29
<PAGE>
PART II. OTHER INFORMATION
---------------------------
ITEM 1. LEGAL PROCEEDINGS
On October 11, 1995, Scrubgrass Generating Company L.P. (the "Lessor") and
Buzzard Power Corporation (the "Lessee") (collectively the "Plaintiffs") filed a
complaint against Pennsylvania Electric Company ("PENELEC") in the Court of
Common Pleas of Venango County, Pennsylvania (the "Court") seeking damages for
certain alleged breaches of the power purchase agreement entered into between
Scrubgrass Power Corporation, a predecessor to the Plaintiffs, and PENELEC on
August 7, 1987. In its complaint, the Plaintiffs allege that PENELEC has failed
to pay contract rates for energy produced by the Scrubgrass facility in excess
of 80 MW in any hour, that PENELEC has misused certain automatic regulation
equipment and that PENELEC has caused the Plaintiffs to incur losses from its
late payment for energy purchased from the Scrubgrass facility. As a result of
PENELEC's alleged failure to pay contract rates for energy produced by the
Scrubgrass facility in excess of 80 MW in any hour, the Plaintiffs estimate that
as of September 30, 1998, after giving effect to certain payments made by
PENELEC which are discussed below, they have incurred damages of approximately
$2.7 million. Should the Plaintiffs prevail in this litigation and be awarded
all of these damages, the Company, as Lessee, would expect to retain 50% of
these damages because of its requirement to pay 50% of any net proceeds retained
by the Scrubgrass Project to the Lessor as additional rent. The Plaintiffs have
yet to quantify their damages from PENELEC's alleged late payments for energy
purchased from the Scrubgrass facility but do not expect that these damages
would be material relative to the other allegations. The Plaintiffs are unable
to quantify the damages they have incurred from PENELEC's alleged misuse of
certain automatic regulation equipment. From October 1995 to September 1996,
this legal proceeding was stayed informally by a letter agreement between the
parties. Pursuant to the letter agreement, PENELEC, which had previously not
made any payments for the energy it received in excess of 80 MW in any hour,
agreed to pay for all energy in excess of 80 MW in any hour, both previously
received and to be received in the future, at a rate equal to 90% of a market
based rate, subject to reimbursement based on the ultimate determination of
PENELEC's responsibility to pay for such energy and the applicable rate
therefor. Through September 30, 1998, the Scrubgrass Project has recognized
cumulative power generation revenues of approximately $1.6 million for energy in
excess of 80 MW in any hour based on the terms established in the letter
agreement. On September 27, 1996, the Plaintiffs provided written notice of
their intention to resume the litigation. Consequently, on October 24, 1996,
PENELEC filed preliminary objections to the complaint to the Court which
principally suggested that the primary jurisdiction for this dispute lies with
the Pennsylvania Public Utility Commission ("PUC"). On November 12, 1996, the
Plaintiffs filed a response to PENELEC's preliminary objections. The Court
heard oral arguments on this matter on January 31, 1997 for which the Court
ultimately decided in favor of the Plaintiffs on September 9, 1997 to deny
PENELEC's motion to transfer the jurisdiction of this dispute to the PUC. On
January 8, 1998, as a result of this ruling by the Court, PENELEC filed its
response to the allegations made in the Plaintiffs' complaint. On February 4,
1998, the Plaintiffs filed a Motion for Partial Judgment on the Pleadings which
was heard by the Court on March 30, 1998. On June 8, 1998, the Venango County
Court of Common Pleas ruled in favor of the Plaintiffs that, under the terms and
conditions of the Scrubgrass power purchase agreement, "PENELEC is required to
purchase all energy produced in good faith, so long as the quantity is not
unreasonably disproportionate to estimate of 80 MW". Presently, pending the
ultimate determination of its responsibility under the power purchase agreement,
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<PAGE>
PENELEC continues to pay for energy in excess of 80 MW at a rate equal to 90% of
a market based rate. The Plaintiffs had been in discussions with PENELEC
concerning a proposal made by PENELEC to settle the litigation. However,
because the Plaintiffs and PENELEC could not come to a mutual agreement on all
of the terms of the proposal, PENELEC withdrew its proposal offer in July 1998
and settlement discussions dissipated. On July 7, 1998, PENELEC filed an appeal
to the Court's order dated June 8, 1998 with the Superior Court of
Pennsylvania. On July 27, 1998, the Plaintiffs filed with the Superior Court of
Pennsylvania a Motion to Quash the Appeal. On September 4, 1998, the Superior
Court of Pennsylvania granted the Plaintiff's Motion to Quash the Appeal. Since
the decision of the Superior Court of Pennsylvania, PENELEC has indicated its
desire to resume settlement discussions. The Plaintiffs and PENELEC are
tentatively scheduled to meet on November 12, 1998 to discuss a possible
settlement of this litigation.
On May 3, 1996, B&W Sunnyside L.P., Babcock & Wilcox Investment Company, NRG
Sunnyside Inc., NRG Energy Inc., and Sunnyside Cogeneration Associates
(collectively the "Plaintiffs") filed a complaint, which was amended on June 27,
1996, against the Company and three of its wholly-owned subsidiaries
(collectively hereafter in this Item 1 "the Company") in Seventh District Court
for Carbon County, State of Utah (the "Court"). The amended complaint alleges
that the Company breached the purchase and sale agreement by which the Company
transferred all of its interest in Sunnyside Cogeneration Associates, a joint
venture which owned and operated a nominal 51 megawatt waste coal fired facility
located in Carbon County, Utah. The amended complaint also alleges that the
Company made certain misrepresentations in connection with the purchase and sale
agreement. As a result of the alleged breaches of contract and
misrepresentations, the Plaintiffs allege that they suffered damages in an
unspecified amount that exceed the aggregate outstanding principal and interest
balances due to the Company by B&W Sunnyside L.P. and NRG Sunnyside, Inc. under
certain notes receivable, which amounted to $2,937,500 and $735,380,
respectively at September 30, 1998. In addition to alleging unspecified
damages, the Plaintiffs also request rescission of the purchase and sale
agreement. On July 26, 1996, in response to the Plaintiffs' amended complaint,
the Company filed an answer and counterclaim. In the answer to the amended
complaint, the Company denied all material allegations of the amended complaint
and asserted numerous affirmative defenses. In the counterclaim, the Company
alleges numerous causes of action against the Plaintiffs which include breach of
contract, breach of the promissory notes, intentional, malicious and willful
breach of contract, intentional tort, interference and misrepresentation.
Through the counterclaim, the Company seeks remedies which include: (1)
compensatory, consequential and punitive damages; (2) acceleration and immediate
payment in full of the promissory notes; and (3) injunctions which require the
Plaintiffs to continue making payments under the promissory notes during the
pendency of this action and until the promissory notes are paid in full and
which enjoin the Plaintiffs from continuing certain malicious and intentional
actions that are alleged in the counterclaim, together with interest, reasonable
attorney's fees, costs and other such relief as the court deems proper. On
August 30, 1996, the Plaintiffs filed a reply to the Company's counterclaim in
which they denied all material allegations of the counterclaim and asserted
numerous affirmative defenses. The Company plans to vigorously defend against
the amended complaint and vigorously pursue the causes of action stated in the
counterclaim. On April 15, 1998, the Company filed a Motion for Summary
Judgment with Respect to Claims Regarding the Power Purchase Agreement, seeking
dismissal of a portion of the Plaintiffs' claims. On June 5, 1998, the Company
received the Plaintiffs' response to its Motion for Summary Judgment with
Respect to Claims Regarding the Power Purchase Agreement wherein the Plaintiffs
stated their opposition to such
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<PAGE>
motion. The Company and the plaintiffs are scheduled to appear in Court on
November 19, 1998 to present oral arguments on the Company's Motion for Summary
Judgment with Respect to Claims Regarding the Power Purchase Agreement.
Discovery remains ongoing.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit 11 - Computation of Earnings Per Share
(b) Reports on Form 8-K - None
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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.
ENVIRONMENTAL POWER CORPORATION
November 9, 1998 /s/ William D. Linehan
------------------------------
William D. Linehan
Treasurer and
Chief Financial Officer
(principal accounting officer
and authorized officer)
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<PAGE>
EXHIBIT 11
ENVIRONMENTAL POWER CORPORATION
COMPUTATION OF EARNINGS PER SHARE
SEPTEMBER 30, 1998
<TABLE>
<CAPTION>
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNTS
------------------ -------------------- ---------------
<S> <C> <C> <C>
THREE MONTHS ENDED SEPTEMBER 30, 1998:
- --------------------------------------
Income available to shareholders $ 437,182 11,406,783 $.04
Effect of dividends to preferred stockholders (1,250)
------------------ -------------------- ---------------
Basic EPS - income available to common shareholders 435,932 11,406,783 .04
Effect of dilutive securities:
Assumed exercise of dilutive stock options 22,597
------------------ -------------------- ---------------
Diluted EPS - income available to common shareholders $ 435,932 11,429,380 $.04
================== ==================== ===============
THREE MONTHS ENDED SEPTEMBER 30, 1997:
- --------------------------------------
Income available to shareholders $1,102,918 11,097,870 $.10
Effect of dividends to preferred stockholders (1,250)
------------------ -------------------- ---------------
Basic EPS - income available to common shareholders 1,101,668 11,097,870 .10
Effect of dilutive securities:
Assumed exercise of dilutive stock options 147,365
------------------ -------------------- ---------------
Diluted EPS - income available to common shareholders $1,101,668 11,245,235 $.10
================== ==================== ===============
<CAPTION>
INCOME (LOSS) SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNTS
------------------- -------------------- ---------------
<S> <C> <C> <C>
NINE MONTHS ENDED SEPTEMBER 30, 1998:
- -------------------------------------
Income available to shareholders $ 54,054 11,406,783 $ ---
Effect of dividends to preferred stockholders (3,750)
------------------- -------------------- ---------------
Basic EPS - income available to common shareholders 50,304 11,406,783 ---
Effect of dilutive securities:
Assumed exercise of dilutive stock options 22,595
------------------- -------------------- ---------------
Diluted EPS - income available to common shareholders $ 50,304 11,429,378 $ ---
=================== ==================== ===============
NINE MONTHS ENDED SEPTEMBER 30, 1997:
- -------------------------------------
Loss available to shareholders $(286,888) 11,083,889 $(.03)
Effect of dividends to preferred stockholders (28,928)
------------------- -------------------- ---------------
Basic EPS - loss available to common shareholders (315,816) 11,083,889 (.03)
Effect of dilutive securities:
Assumed exercise of dilutive stock options 134,137
------------------- -------------------- ---------------
Diluted EPS - loss available to common shareholders $(315,816) 11,218,026 $(.03)
=================== ==================== ===============
</TABLE>
WARNING: THE EDGAR SYSTEM ENCOUNTERED ERROR(S) WHILE PROCESSING THIS SCHEDULE.
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS OF ENVIRONMENTAL POWER CORPORATION AS OF
SEPTEMBER 30, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 1,065,344<1>
<SECURITIES> 0
<RECEIVABLES> 9,788,558<2><3>
<ALLOWANCES> 0
<INVENTORY> 570,132
<CURRENT-ASSETS> 8,115,609
<PP&E> 247,599
<DEPRECIATION> 142,746
<TOTAL-ASSETS> 55,478,897
<CURRENT-LIABILITIES> 9,701,820
<BONDS> 3,482,246
0
100
<COMMON> 125,254
<OTHER-SE> (4,806,185)
<TOTAL-LIABILITY-AND-EQUITY> 55,478,897
<SALES> 33,545,710
<TOTAL-REVENUES> 33,545,710
<CGS> 14,313,809
<TOTAL-COSTS> 14,313,809
<OTHER-EXPENSES> 17,301,399
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 357,164
<INCOME-PRETAX> 83,054
<INCOME-TAX> 29,000
<INCOME-CONTINUING> 54,054
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 54,054
<EPS-PRIMARY> 0.00
<EPS-DILUTED> 0.00
<FN>
<F1>INCLUDES CASH OF $698,978 WHICH IS RESTRICTED IN USE.
<F2>INCLUDES RECEIVABLES OF $3,523,097 WHICH ARE NONCURRENT.
<F3>INCLUDES RECEIVABLES OF $3,508,498 WHICH ARE SUBJECT TO A LEGAL PROCEEDING.
</FN>
</TABLE>
