PNW

Business Context and Reporting Period

This Form 10-K is a combined annual report for Pinnacle West Capital Corporation (the holding company) and its major subsidiary, Arizona Public Service Company (APS), for the fiscal year ended December 31, 2006. Pinnacle West is an Arizona corporation that owns all outstanding equity of APS, a vertically-integrated electric utility serving most of Arizona. The company operates two principal segments: Regulated Electricity (77% of 2006 operating revenues) and Real Estate (12% of 2006 operating revenues, via subsidiary SunCor). Marketing and trading activities were reclassified to "Other" in 2006 as the company deemphasized this segment.

Key Financial Metrics (2006)

Material Changes vs. Prior Period

• Net Income Growth: Consolidated net income increased to $327.3 million in 2006 from $176.3 million in 2005. This $151 million increase was driven primarily by the absence of a $56 million after-tax loss from discontinued operations (Silverhawk) recorded in 2005 and a $94 million increase in income from continuing operations.
• Regulated Electricity Segment: Income from continuing operations increased approximately $92 million. This was largely due to the absence of an $84 million after-tax regulatory disallowance of plant costs recorded in 2005. Higher retail sales volumes due to customer growth and income tax credits also contributed.
• Real Estate Segment: Income from continuing operations increased $15 million, driven by higher margins on residential sales and the sale of joint venture assets.
• Discontinued Operations: In 2006, the company recorded a $10 million gain from discontinued operations (primarily SunCor commercial property sales), compared to a $47 million loss in 2005 (primarily the sale of Silverhawk).
• Debt Structure: Long-term debt increased significantly as the company issued new notes to fund capital expenditures and refinance maturing debt. Pinnacle West issued $175 million in senior notes in February 2006, and APS issued $400 million in notes in August 2006.

Guidance, Outlook, and Risks

• Rate Proceedings: The primary financial outlook driver is the resolution of APS's retail rate proceedings before the Arizona Corporation Commission (ACC). APS is requesting a 20.4% ($434.6 million) increase in annual retail revenues. A decision is expected in the second quarter of 2007.
• Power Supply Adjustor (PSA): Approximately $160 million in fuel and purchased power costs were deferred under the PSA at year-end. This includes $45 million related to 2005 Palo Verde outages and $79 million related to 2006 outages. The ACC staff has recommended disallowing $17 million of the 2005 costs, though management contests this.
• Capital Expenditures: Estimated capital expenditures are projected to rise from $870 million in 2006 to $1,037 million in 2007, $1,070 million in 2008, and $1,211 million in 2009, driven by transmission, distribution, and generation upgrades.
• Real Estate Outlook: SunCor's net income is expected to slow in 2007 (estimated $30–$35 million) due to a slowdown in western U.S. residential real estate markets.
• Key Risks:
  • Regulatory Risk: Delays or disallowances in rate recovery, particularly regarding Palo Verde outage costs.
  • Environmental Compliance: Potential costs associated with EPA regional haze rules, mercury emissions, and Superfund liabilities.
  • Nuclear Operations: Risks related to Palo Verde outages, decommissioning costs, and NRC inspections (a "white" finding was issued in early 2007 regarding generator issues).
  • Market Risk: Exposure to commodity price fluctuations (natural gas, coal) and interest rate changes.

Investor Verification Checklist

• Rate Case Outcome: Verify the ACC's final decision on the 20.4% rate increase request and the prudence review of Palo Verde outage costs ($124 million total deferred).
• Discontinued Operations: Confirm the final tax implications and cash proceeds from the Silverhawk sale and SunCor commercial property sales.
• Capital Expenditure Funding: Monitor the company's ability to fund the projected $1+ billion annual capital program through internal cash flow and external financing without credit rating downgrades.
• Real Estate Exposure: Assess the impact of the slowing housing market on SunCor's inventory and future earnings guidance.
• Environmental Liabilities: Review updates on the Motorola Superfund site investigation and potential costs for mercury emission controls.