PNW

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended September 30, 2007, for Pinnacle West Capital Corporation (Pinnacle West) and its primary subsidiary, Arizona Public Service Company (APS). Pinnacle West is a holding company whose principal subsidiary, APS, is a vertically integrated electric utility serving most of Arizona. The company operates two primary reportable segments: Regulated Electricity and Real Estate (SunCor). The filing includes unaudited condensed consolidated financial statements.

Key Financial Metrics

Three Months Ended September 30, 2007 (vs. 2006):

• Total Operating Revenues: $1.206 billion (up from $1.076 billion).
• Net Income: $208.7 million (up from $184.2 million).
• Earnings Per Share (Diluted): $2.07 (up from $1.84).
• Operating Income: $338.8 million (up from $310.4 million).

Nine Months Ended September 30, 2007 (vs. 2006):

• Total Operating Revenues: $2.765 billion (up from $2.672 billion).
• Net Income: $304.2 million (down slightly from $308.8 million).
• Earnings Per Share (Diluted): $3.02 (down from $3.10).
• Operating Income: $565.5 million (up from $558.8 million).

Liquidity and Balance Sheet (as of Sept 30, 2007):

• Cash and Cash Equivalents: $43.9 million (down from $87.2 million at year-end 2006).
• Total Assets: $11.40 billion.
• Total Liabilities: $7.83 billion.
• Long-Term Debt: $3.23 billion (excluding current maturities).
• Short-Term Borrowings: $273.6 million.
• Common Stock Equity: $3.57 billion.

Cash Flows (Nine Months Ended Sept 30, 2007):

• Operating Cash Flow: $477.5 million provided (up from $283.2 million).
• Investing Cash Flow: $678.1 million used (up from $560.3 million used), driven by capital expenditures of $710.4 million.
• Financing Cash Flow: $157.3 million provided (down from $251.3 million provided).

Material Changes vs. Prior Period

• Regulatory Rate Increase: Effective July 1, 2007, the Arizona Corporation Commission (ACC) approved a retail rate increase for APS, adding approximately $322 million in annual retail base revenues. This significantly boosted regulated electricity segment revenues.
• Real Estate Segment Decline: The Real Estate segment (SunCor) saw a sharp decline in income due to the slowdown in western U.S. real estate markets. For the nine months ended Sept 30, 2007, real estate segment income from continuing operations dropped approximately $40 million compared to the prior year.
• Discontinued Operations: The company recorded income from discontinued operations of $7.7 million for the quarter and $8.9 million for the nine-month period, primarily from the sale of commercial properties by SunCor.
• Regulatory Disallowance: The ACC disallowed approximately $14 million of 2005 deferrals related to Palo Verde outages, citing imprudence. This resulted in an after-tax charge of approximately $8 million.
• Weather Impact: Hotter weather in the third quarter of 2007 increased retail sales and revenues compared to the prior year.

Guidance, Outlook, and Risks

Management Commentary and Outlook:

• Customer Growth: APS customer growth is approximately 3.5% for the nine months ended Sept 30, 2007. Management expects average annual customer growth of about 3.0% from 2007 to 2009.
• Capital Expenditures: Estimated capital expenditures for the full year 2007 are $1.1 billion, with $1.07 billion for 2008 and $1.24 billion for 2009. Major projects include transmission upgrades and the replacement of steam generators at Palo Verde Unit 3.
• Dividends: A quarterly dividend of $0.525 per share was declared on October 17, 2007, payable December 3, 2007.
• Real Estate Outlook: SunCor's net income for 2007 is estimated at approximately $20 million, reflecting the continued slowdown in the real estate market and deteriorating credit conditions.

Risks and Contingencies:

• Regulatory Risk: Future profitability depends on the timely recovery of costs through rates. The ACC is conducting a "prudence audit" of 2006 Palo Verde outage costs ($79 million deferred); while the staff report deemed the response "reasonable and prudent," final recovery is pending.
• Environmental Compliance: The company faces potential costs related to Regional Haze Rules (BART analyses) for Cholla, West Phoenix, and Four Corners plants. A Federal Implementation Plan (FIP) for Four Corners was adopted by the EPA in April 2007, which the company is challenging.
• Market Risk: Exposure to commodity price fluctuations (natural gas, electricity) is managed through hedging. A 10% price increase in natural gas could impact the fair value of risk management assets by approximately $76 million.
• Legal Proceedings: Ongoing litigation includes the Navajo Nation lawsuit regarding coal royalties and Superfund liability at the Motorola 52nd Street site.

Investor Verification Checklist

• Verify the final outcome of the ACC's prudence audit regarding the $79 million in 2006 Palo Verde outage deferrals.
• Monitor the resolution of the IRS examination regarding the 2001 tax accounting method change, which involves a $200 million deduction and uncertain tax positions of approximately $210 million.
• Track the progress and cost implications of the Regional Haze Rule (BART) analyses for Cholla and Four Corners plants.
• Assess the impact of the continued slowdown in the western U.S. real estate market on SunCor's ability to meet its projected 2007 net income of $20 million.
• Review the status of the FERC proceedings regarding market-based rates in the APS control area and potential refund obligations from California energy market issues.