PNW

Business Context and Reporting Period

This Form 10-K is a combined annual report for Pinnacle West Capital Corporation (the parent company) and its major subsidiary, Arizona Public Service Company (APS), for the fiscal year ended December 31, 2004. Pinnacle West is an Arizona corporation holding all outstanding equity of APS, a vertically-integrated electric utility serving most of Arizona. The company operates through three primary segments: Regulated Electricity (70% of 2004 revenue), Marketing and Trading (16%), and Real Estate (12%, via SunCor).

Key Financial Metrics (2004)

Material Changes vs. Prior Period (2003)

• Net Income: Consolidated net income increased slightly by $2.6 million (1.1%) to $243.2 million, driven by a $21 million after-tax gain from the sale of El Dorado's interest in the Phoenix Suns and improved marketing/trading results, partially offset by lower regulated electricity earnings.
• Regulated Electricity Segment: Net income decreased by approximately $19 million due to higher interest and depreciation costs from new power plants, increased operations and maintenance costs, and milder weather reducing retail sales. These were partially offset by customer growth and lower regulatory asset amortization.
• Marketing and Trading Segment: Net income increased by $9 million, primarily due to higher forward and realized wholesale electricity prices.
• Real Estate Segment: Net income decreased by $11 million, largely due to the absence of a 2003 gain on the sale of a water utility company (reclassified as discontinued operations) and decreased asset sales.
• Discontinued Operations: The company reported $8.0 million in income from discontinued operations in 2004 (SunCor and NAC sales), compared to $14.8 million in 2003.

Guidance, Outlook, and Risks

Outlook and Guidance

• Rate Case: The key issue affecting the outlook is the APS general rate case pending before the Arizona Corporation Commission (ACC). A 2004 Settlement Agreement proposes a 4.21% rate increase and the transfer of Pinnacle West Energy assets to APS. An administrative law judge issued a recommended order in February 2005, but the final ACC decision is pending.
• Customer Growth: Customer growth in APS's service territory averaged 3.4% annually from 2002-2004. Management expects growth to average 3.8% annually from 2005-2007.
• Capital Expenditures: Estimated capital expenditures for 2005 are $901 million (consolidated), with $772 million allocated to APS for delivery and generation upgrades, including the planned acquisition of the Sundance Plant ($190 million).
• SunCor: SunCor expects net income of approximately $50 million in 2005 and cash distributions to the parent of $80-$100 million based on accelerated asset sales.

Risks and Contingencies

• Regulatory Uncertainty: Outcomes of the rate case, retail electric competition rules, and FERC proceedings regarding market-based rates could materially impact financial results.
• Environmental and Legal: Ongoing litigation regarding Navajo Nation environmental issues, water rights adjudications, and Superfund liabilities (e.g., Motorola 52nd Street site) present potential costs, though management does not currently expect a material adverse impact.
• Market Risks: Exposure to fluctuations in electricity and natural gas prices, as well as credit risk from counterparties in trading activities.
• Plant Performance: Risks related to power plant outages and transmission constraints, which can increase replacement power costs.

Investor Verification Checklist

• Rate Case Outcome: Verify the final ACC decision on the 2004 Settlement Agreement, specifically regarding the Power Supply Adjuster (PSA) and the transfer of Pinnacle West Energy assets to APS.
• Sundance Plant Acquisition: Confirm the closing of the $190 million acquisition of the Sundance Plant from PPL Sundance and its impact on rate base.
• Regulatory Asset Amortization: Monitor the amortization of regulatory assets, which significantly impacted earnings in 2004 ($18 million) compared to prior years.
• Discontinued Operations: Review the final tax and accounting treatment of the NAC and SunCor discontinued operations to ensure accurate comparison of continuing operations.
• Debt Covenants: Verify continued compliance with debt-to-capitalization ratios (currently ~53-54%) and interest coverage ratios (currently ~4x) to avoid default triggers.