Business Context and Reporting Period
Company: Pinnacle West Capital Corporation (PINNACLE WEST)
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2002
Pinnacle West is a holding company primarily owning Arizona Public Service Company (APS), a regulated electric utility serving most of Arizona. The company operates through three main segments: Regulated Electricity (76% of 2002 revenue), Marketing and Trading (12%), and Real Estate (9%). The reporting period was significantly impacted by regulatory changes in Arizona regarding retail electric competition, specifically the Arizona Corporation Commission's (ACC) "Track A Order" which halted the planned transfer of generation assets to the competitive subsidiary, Pinnacle West Energy.
Key Financial Metrics
| Metric | 2002 | 2001 |
|---|---|---|
| Total Operating Revenues | $2,637 million | $3,394 million |
| Net Income | $149 million | $312 million |
| Income Before Accounting Change | $215 million | $327 million |
| Earnings Per Share (Diluted) | $1.76 | $3.68 |
| Total Assets | $8,426 million | $7,939 million |
| Long-Term Debt (less current) | $2,882 million | $2,673 million |
| Cash and Cash Equivalents | $78 million | $29 million |
| Dividends Declared Per Share | $1.625 | $1.525 |
Material Changes vs. Prior Period
- Net Income Decline: Net income dropped 52% to $149 million from $312 million in 2001. This decrease was driven by a $66 million after-tax charge for a change in accounting for trading activities (EITF 02-3), lower earnings from marketing and trading due to weak wholesale power markets, and significant one-time charges.
- One-Time Charges: The company recorded a $49 million pretax write-off for the cancellation of Redhawk Units 3 and 4 and approximately $36 million in severance costs related to a voluntary workforce reduction.
- Segment Performance:
- Regulated Electricity: Gross margin increased by $112 million due to lower replacement power costs and customer growth, partially offset by retail price reductions and milder weather.
- Marketing and Trading: Gross margin decreased by $185 million due to lower market prices, reduced liquidity, and lower realized wholesale margins.
- Real Estate: Gross margin increased by $16 million due to increased sales activity by SunCor.
- Other (NAC): Pretax losses of $59 million were recorded related to the investment in NAC (spent nuclear fuel technology), primarily due to contract losses with two customers.
- Regulatory Shift: The ACC's Track A Order reversed the requirement to transfer generation assets to Pinnacle West Energy, altering the company's capital structure and competitive strategy.
Guidance, Outlook, and Risks
- Regulatory Outlook: The company's financial outlook is heavily dependent on pending ACC matters, including a $500 million financing application (approved March 27, 2003) to support Pinnacle West Energy, a mandated competitive procurement process for power (Track B Order), and a general rate case to be filed in 2003.
- Capital Needs: Estimated capital expenditures for 2003 are $750 million, primarily for APS transmission/distribution and Pinnacle West Energy generation construction. The company expects to refinance approximately $475 million of parent company indebtedness in mid-2003.
- Real Estate Strategy: Management plans to accelerate asset sales for SunCor to double annual earnings in the 2003-2005 period and enable cash distributions of $80-$100 million annually to the parent company.
- Key Risks:
- Regulatory Uncertainty: Outcomes of the ACC rate case and competitive procurement rules could impact revenue recovery and cost structures.
- Wholesale Market Conditions: Earnings from marketing and trading are volatile and dependent on western U.S. wholesale power prices and liquidity.
- Environmental and Litigation: Risks include potential costs related to nuclear waste disposal, Clean Air Act compliance, and ongoing litigation regarding California energy market refunds and NAC contracts.
- Accounting Changes: Adoption of new standards (EITF 02-3, SFAS 143) resulted in significant charges and balance sheet adjustments.
Investor Verification Checklist
- Regulatory Resolution: Verify the final outcome of the APS general rate case (expected decision by end of 2004) regarding the recovery of the $234 million asset write-off and rate base treatment of Pinnacle West Energy assets.
- Financing Execution: Confirm the execution of the $500 million financing arrangement between APS and Pinnacle West Energy approved in March 2003 to ensure Pinnacle West Energy maintains investment-grade credit.
- NAC Exposure: Monitor the status of the Maine Yankee litigation and the financial stability of NAC, given the $59 million loss recorded in 2002.
- Wholesale Market Trends: Assess the recovery of wholesale power market liquidity and pricing in the western U.S. to gauge the potential for improved Marketing and Trading segment earnings.
- Capital Expenditure Funding: Review the company's ability to fund the $750 million 2003 capital program and refinance $475 million of maturing debt without adverse credit rating impacts.