PNW

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended September 30, 2006, for Pinnacle West Capital Corporation (Pinnacle West) and its primary subsidiary, Arizona Public Service Company (APS). Pinnacle West is a holding company owning 100% of APS, a vertically integrated electric utility serving most of Arizona. The company operates through three segments: Regulated Electricity, Real Estate (SunCor), and Marketing and Trading. The filing includes unaudited condensed consolidated financial statements.

Key Financial Metrics (Nine Months Ended Sept 30, 2006)

Material Changes vs. Prior Period

• Net Income Surge: Net income increased 99% year-over-year ($153.9 million increase). This is primarily driven by a one-time $87 million after-tax regulatory disallowance of plant costs recorded in the prior year (2005) related to the APS retail rate case settlement.
• Revenue Growth: Total revenues increased 16% ($375.4 million). The Regulated Electricity segment saw a $317 million increase, largely due to the recovery of deferred fuel costs ($195 million) and customer growth ($102 million).
• Discontinued Operations: The 2005 period included a $64 million after-tax loss from the sale of the Silverhawk Power Station. The 2006 period reflects minimal discontinued operations activity.
• Fuel Cost Deferrals: APS deferred approximately $209 million in fuel and purchased power costs as of September 30, 2006, under the Power Supply Adjustor (PSA) mechanism. This includes $78 million related to unplanned Palo Verde outages in 2006.
• Real Estate Segment: SunCor contributed significantly to earnings, with income from continuing operations increasing $21 million due to higher margins on residential sales and joint venture asset sales.

Guidance, Outlook, Risks, and Contingencies

• Regulatory Proceedings (Key Risk): APS is in a general rate case before the Arizona Corporation Commission (ACC), requesting a 20.4% ($434.6 million) revenue increase. The ACC staff has recommended a lower increase of approximately 9.2% ($195.8 million). The outcome of this proceeding is the primary factor affecting future financial results.
• Palo Verde Prudence Review: The ACC staff recommended disallowing approximately $17.4 million of costs related to unplanned 2005 Palo Verde outages. APS contests this, believing the costs were prudently incurred. A similar prudence audit is underway for 2006 outage costs ($78 million).
• FERC Order: The FERC revoked Pinnacle West's market-based rate authority in the APS control area in April 2006, requiring a shift to cost-based rates and potential refunds for prior sales. Management does not currently expect a material adverse effect.
• Capital Requirements: Estimated capital expenditures for 2006 are $861 million, with significant spending on generation (including Palo Verde steam generators) and transmission/distribution to support customer growth.
• Accounting Changes: The company is evaluating the impact of new FASB standards (SFAS 158 on pensions and FIN 48 on income taxes), which may increase balance sheet liabilities but are not expected to materially impact operations due to regulatory asset offsets.

Investor Verification Checklist

• Rate Case Outcome: Monitor the final ACC decision on the general rate case and the specific treatment of the $123 million in PSA deferrals related to Palo Verde outages.
• Fuel Cost Recovery: Verify the timeline and amount of future PSA adjustor approvals to recover the $209 million deferred fuel balance.
• FERC Refunds: Track the final calculation of refunds required due to the FERC order revoking market-based rates in the APS control area.
• Capital Expenditure Execution: Confirm progress on the Palo Verde Unit 3 steam generator replacement ($70 million APS share) and other generation projects.
• Real Estate Market: Assess SunCor's continued performance given its reliance on the Arizona real estate market for earnings.