PNW

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended March 31, 2010, for Pinnacle West Capital Corporation (Pinnacle West) and its primary subsidiary, Arizona Public Service Company (APS). Pinnacle West is a holding company whose operations are primarily conducted through APS, a vertically integrated electric utility serving most of Arizona. The filing also includes the real estate segment, SunCor, which is in the process of disposing of assets due to distressed market conditions.

Key Financial Metrics

Note: The significant improvement in net loss compared to Q1 2009 is primarily due to a reduction in real estate impairment charges.

Material Changes vs. Prior Period

• Real Estate Impairment: The consolidated net loss improved by $151 million compared to Q1 2009. This was driven by a decrease in real estate impairment charges from $202 million in Q1 2009 to $15 million in Q1 2010.
• Regulated Electricity Segment: Net income for the regulated segment increased by $27 million to $7 million, primarily due to retail rate increases effective January 1, 2010, and higher revenues from line extensions and transmission rates.
• Operating Expenses: Operations and maintenance expenses increased by $13 million, largely due to higher labor costs and demand-side management programs, partially offset by lower generation costs.
• Accounting Changes: The company adopted amended accounting guidance for Variable Interest Entities (VIEs) on January 1, 2010, resulting in the consolidation of Palo Verde Lessor Trusts. This increased reported debt and assets but did not impact net income attributable to Pinnacle West shareholders.

Guidance, Outlook, and Risks

• Capital Requirements: A 2009 rate case settlement requires APS to receive equity infusions of at least $700 million by December 31, 2014. In April 2010, Pinnacle West issued common stock raising $253 million, all of which was contributed to APS.
• Capital Expenditures: Estimated capital expenditures for 2010 are $820 million, with significant portions allocated to generation ($309 million) and distribution ($281 million).
• Renewable Energy: APS is committed to the "AZ Sun" program, investing up to $500 million through 2014 to own 100 MW of photovoltaic power plants.
• SunCor Liquidity Risk: SunCor's real estate subsidiary faces liquidity challenges. Its primary secured revolver matured in January 2010, and a forbearance agreement is in place until June 30, 2010. Pinnacle West does not guarantee SunCor debt, and a default would not trigger a cross-default for the parent company, though SunCor's ability to generate cash is uncertain.
• Regulatory and Environmental Risks: The company faces potential costs from greenhouse gas emission regulations (e.g., EPA rules, Western Climate Initiative) and coal combustion waste disposal regulations. Management believes these costs can be recovered through rates.

Investor Verification Checklist

• SunCor Debt Resolution: Verify the status of SunCor's negotiations with lenders regarding the matured $54 million secured revolver and other credit facilities.
• Equity Infusion Schedule: Monitor the timing and execution of the remaining equity infusions required by the Arizona Corporation Commission (ACC) to meet the $700 million target by 2014.
• Real Estate Asset Sales: Track the progress of SunCor's strategic asset sales to determine if remaining assets can be sold at values sufficient to repay outstanding debt.
• Regulatory Rate Recovery: Confirm the implementation of the 2008 rate case settlement terms, specifically the recovery of renewable energy and demand-side management costs.
• Environmental Compliance Costs: Assess the potential financial impact of new EPA regulations regarding coal combustion waste and greenhouse gas emissions on future capital expenditures.