ITEM 3: LEGAL PROCEEDINGS
On October 9, 1992, Jack J. Grynberg filed suit in the United States District Court for the District of Colorado against the Company, RMNG and GASCO, Inc. (the "K N Entities") alleging that the K N Entities as well as K N Production Company and K N Gas Gathering, Inc., have violated federal and state antitrust laws. In essence, Grynberg asserts that the defendant companies have engaged in an illegal exercise of monopoly power, have illegally denied him economically feasible access to essential facilities to transport and distribute gas produced from fewer than 20 wells located in northwest Colorado, and have illegally attempted to monopolize or to enhance or maintain an existing monopoly. Grynberg also asserts certain causes of action relating to a gas purchase contract. On February 5, 1999, the Federal District Court granted summary judgment regarding some of Grynberg's antitrust and state law claims, while allowing other claims to proceed to trial. The Company's potential liability and the amount of such damages, if any, are subject to dispute between the parties; however, the Company believes it has a meritorious position in these matters and does not expect this lawsuit to have a material adverse effect on the Company's business, financial position or results of operations. In July 1996, the U.S. District Court, District of Colorado lifted its stay and allowed discovery for a period of time. Currently, this case is still pending. Discovery is now complete, but no trial date has yet been set.
On July 26, 1996, the Company and RMNG, along with over 70 other natural gas companies, were served by Jack J. Grynberg, acting on behalf of the Government of the United States, with a Civil False Claims Act lawsuit alleging mismeasurement of the heating content and volume of natural gas resulting in underpayment of royalties to the federal government. The Company and the other named companies filed a motion to dismiss the lawsuit on grounds of improper joinder and lack of jurisdiction. The motion was granted in 1997, but the court gave Mr. Grynberg leave to refile this action in a court with proper jurisdiction. Mr. Grynberg appealed the dismissal of the action based on improper joinder, and the D.C. Court of Appeals affirmed the joinder decision in October 1998. Mr. Grynberg has filed a new case, modified somewhat from his original action, in Federal District Court, District of Colorado. The Company has not yet been served in this new action, which is under seal pending federal governmental reviews of the merits. The Department of Justice has not yet made a decision regarding whether to intervene in this new case. The Company has engaged in both formal and informal discussions with the Government regarding this case. The Company believes it has a meritorious position in this matter, and does not expect this lawsuit to have a material adverse effect on the Company's business, financial position or results of operations.
Pursuant to certain acquisition agreements involving Cabot Corporation ("Cabot"), Cabot indemnified the Company for certain environmental liabilities associated with assets in Texas, Oklahoma and New Mexico acquired from American Oil and Gas Corporation. Issues arose concerning Cabot's indemnification obligations, and the Company and Cabot entered into binding arbitration to resolve all issues in dispute. The binding decision of the arbitrators resulted in the requirement that Cabot pay the Company for a substantial portion of past and future environmental related costs associated with the properties. In December 1998, the Company recorded a charge of approximately $7.2 million representing both previously incurred costs which were not awarded in the arbitration and the recognition of a liability for the Company's share of estimated future costs. As a result of this settlement, the Company will have no future expense associated with this matter. The Company does not expect its potential exposure for the remaining liabilities to have a material adverse effect on the Company's business, financial position or results of operations.
The Company believes it has meritorious defenses to all lawsuits and legal proceedings in which it is a defendant and will vigorously defend against them. Based on its evaluation of the above matters, and after consideration of reserves established, the Company believes that the resolution of such matters will not have a material adverse effect on the Company's business, financial position or results of operations.
EXECUTIVE OFFICERS OF THE REGISTRANT
(A) Identification and Business Experience of Executive Officers
These officers generally serve until April of each year.
(B) Involvement in Certain Legal Proceedings
None.
PART II
ITEM 5:
ITEM 5: MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Company's common stock is listed for trading on the New York Stock Exchange under the symbol KNE. Dividends paid and the price range of the Company's common stock by quarter for the last two years are provided below. All amounts have been restated to reflect the three-for-two split of the Company's common stock effective December 31,1998.
ITEM 6:
ITEM 6: SELECTED FINANCIAL DATA
FIVE-YEAR REVIEW K N ENERGY, INC. AND SUBSIDIARIES
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
The following discussion should be read in conjunction with the accompanying consolidated financial statements and related notes. As discussed in Note 2 to the accompanying consolidated financial statements, the Company has engaged in acquisition and divestiture transactions which may affect the comparison of results between periods. All per share amounts reflect the impact of the December 31, 1998, three-for-two common stock split as discussed in Note 7 (D) to the accompanying consolidated financial statements.
On February 22, 1999, Sempra Energy ("Sempra," an energy services holding company based in San Diego, California) and the Company announced that their respective boards of directors had approved a definitive agreement under which Sempra and the Company would combine in a stock and cash transaction. This merger is conditioned, among other things, upon the approvals of shareholders of both companies as well as certain regulatory approvals, including approvals of the Federal Energy Regulatory Commission and clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. For additional information, see Note 1 to the accompanying consolidated financial statements.
CONSOLIDATED FINANCIAL RESULTS
The Company's results for 1998 reflect increases from 1997 of 104.2 percent in operating revenues, 134.6 percent in gross margin and 135.9 percent in operating income. These increases are due, in large part, to the inclusion of the results of operations of MidCon Corp. ("MidCon") beginning with its January 30, 1998, acquisition date.
The operating revenues, gross margin and operating income associated with each of the Company's business segments were negatively affected during 1998 by (i) low natural gas liquids ("NGLs") prices and associated reduced processing margins and (ii) reduced pipeline basis differentials reflecting, in part, weather-related reduction in demand as further described within the individual segment discussions which follow. In addition, the results of operations for 1998 include (i) $5.8 million of pre-tax expense ($3.5 million after tax or $0.05 per diluted share) associated with the January 30, 1998, acquisition of MidCon by K N and (ii) the negative impact of items totaling approximately $27.8 million before tax ($17.0 million after tax or $0.26 per diluted share). The pre-tax loss associated with these items includes (i) $7.2 million attributable to settlement of the arbitration of certain environmental litigation as a result of which the Company will have no future expense associated with this matter, (ii) a loss of $3.1 million resulting from the sale of several under-performing natural gas processing facilities, (iii) write-downs totaling approximately $8.8 million due to the revaluation of certain natural gas due from third-parties and in underground storage and NGLs inventories to reflect current market values, (iv) $3.7 million in increased allowances for uncollectible accounts receivable and (v) $5.0 million of increased provisions for regulatory refund obligations. These charges were partially offset by the $8.5 million pre-tax ($5.2 million after tax or $0.08 per diluted share) gain from the sale of the Company's Kansas distribution properties and the
$10.9 million pre-tax ($6.7 million after tax or $0.10 per diluted share) gain from the sale of certain microwave towers.
There was a significant increase in interest expense in 1998 and an increase in the effective tax rate, see "Other Income and (Deductions)" and "Income Taxes" elsewhere herein. Earnings per diluted share for 1998 declined by 43.6 percent from 1997 reflecting, in addition to the decline in 1998 net income, an increase of 36.6 percent in average shares outstanding, largely due to the March 1998 common stock issuance associated with the acquisition of MidCon (see Notes 2(D) and 7(D) to the accompanying consolidated financial statements).
RESULTS OF OPERATIONS
Reflecting the Company's strategy of extracting margins from the various segments of the energy value stream, the Company has segregated its results of operations into "Upstream," "Midstream" and "Downstream" components. The Company's Upstream operations consist of (i) natural gas gathering, (ii) natural gas processing and (iii) NGLs extraction and marketing activities. Midstream operations consist of transportation, storage and bundled sales transactions for K N's interstate and intrastate pipelines. Downstream activities principally consist of energy marketing, regulated natural gas distribution and electric power generation and sales. For comparative purposes, the Company's previously reported segment results have been restated to conform to the current presentation. The following segment data are before intersegment eliminations.
Operating revenues and operating expenses for Upstream increased by $50.9 million and $128.1 million, respectively, from 1997 to 1998 due primarily to the effect of a full year of the results of operations of the Bushton processing facility. Upstream operating income decreased from income of $58.8 million in 1997 to a loss of $18.4 million in 1998. This net decrease of $77.2 million included $14.0 million of positive contribution from the 1998 operating results of assets which were not included in 1997 operating results, including assets acquired with the MidCon, Red Cedar Gathering Company and Interenergy Corporation acquisitions. This positive impact was more than offset by approximately $91.2 million of negative variance associated with assets owned and operated during both periods. Approximately 55 percent of this negative variance was attributable to decreased NGLs prices during 1998. The addition of the Bushton facility in April 1997 was accretive to 1997 earnings. However, due in part to its contract mix, this acquisition increased Upstream's sensitivity to NGLs
prices and to the spread between NGLs prices and natural gas prices. The remaining negative variance was principally due to the impacts of (i) increased 1998 downtime resulting from plant turnaround and installation of additional measurement facilities, (ii) operational problems in 1998 associated with deficient vendor performance, (iii) reduced 1998 pipeline basis differentials which negatively affected joint venture marketing activities, (iv) 1998 NGLs storage inventory write-downs and (v) reduced 1998 revenues from the sale of NGLs marketing rights and processing agreements.
The significant increases in 1997 operating revenues, costs and expenses and volumetric data over 1996 largely reflect the acquisition of the Bushton gathering and processing assets effective April 1, 1997. Increased 1997 operating income from the Bushton assets was partially offset by lower 1997 NGLs prices received at other processing facilities.
Midstream operating income increased from $45.5 million in 1997 to $352.1 million in 1998. This increase in operating income, as well as the significant increases in operating revenues, operating expenses and throughput shown in the preceding table, was principally attributable to the inclusion in 1998 of the operating results of (i) the interstate and intrastate pipeline operations of assets acquired with MidCon (see Note 2 (D) to the accompanying consolidated financial statements) and (ii) the Pony Express Pipeline, which began full operation in the fourth quarter of 1997. There was no significant variance attributable to the operating results of assets owned in both periods.
The Pony Express Pipeline accounted for the majority of the improvement in Midstream operating income from 1996 to 1997. Additionally, 1997 operating results were positively affected by increased gas supply requirements for the Company's retail natural gas services and other wholesale customers. These gas supply requirements increased in 1997 principally due to colder weather and higher irrigation demand in the northern portions of the Company's operating area. These positive impacts were partially offset by reduced 1997 wholesale irrigation demand in the Texas intrastate market area and the transfer of the Casper processing plant to the Upstream segment in August 1997.
Downstream operating income decreased from $41.8 million in 1997 to $16.7 million in 1998 primarily due to a decrease in earnings from commodity marketing and other factors as described following. Operating income for 1998 included $8.0 million of income from certain new assets and businesses not included in 1997, including K N Power, the Thermo Companies ("Thermo"), K N Telecommunications and the Company's interest in the Hermosillo, Mexico, natural gas distribution system. Additionally, 1998 results, as compared to 1997, were positively affected by the fact that 1997 results included approximately $4.0 million of power marketing losses (the Company is not currently engaged in power marketing). However, these favorable variances were more than offset by (i) a $4.6 million decrease attributable to equity in losses of en*able and (ii) a decrease of $26.8 million in operating income from commodity marketing, which reflected (1) $6.4 million of adjustments to write down certain natural gas due from third parties and in underground storage to their current market values, (2) $3.7 million of increased provision for uncollectible accounts receivable, (3) reduced 1998 sales of gas in storage and (4) depressed 1998 basis differentials and milder weather which have a negative impact on certain sales margins due to the costs associated with transportation commitments.
Downstream results were positively affected in 1997, relative to 1996, by increased sales of gas in storage, sales of certain non-strategic gas supply and increases in space-heating and irrigation loads in the northern portions of the Company's operating area. These positive impacts were more than offset by (i) $4.0 million of 1997 power marketing losses, (ii) reduced 1997 wholesale irrigation demand in the Texas intrastate markets and (iii) expenses incurred during 1997 to centralize the Company's marketing activities in Houston, Texas.
The increase of $203.7 million in "Interest Expense, Net" from 1997 to 1998 was principally due to incremental debt associated with the MidCon acquisition and construction costs associated with the Pony Express Pipeline. The increase in net expense associated with "Minority Interests" in 1998, relative to 1997, was principally due to the dividend requirements associated with the $175 million of Capital Trust Securities issued in April 1998. The $2.1 million decrease in "Other, Net" from 1997 to 1998 reflects the fact that 1998 included (i) a $10.9 million gain from the sale of certain microwave towers, (ii) an $8.5 million gain from the sale of the Company's Kansas natural gas distribution properties, (iii) the recognition of $7.2 million in costs related to the settlement of the arbitration of certain environmental claims, as a result of which the Company will have no future expense associated
with this matter, (iv) approximately $5.0 million of expense reflecting an increased provision for regulatory refund obligations, (v) a loss of approximately $3.1 million from the sale of certain natural gas processing facilities and (vi) $13 million of other miscellaneous income items, while 1997 included approximately $7.0 million of income related to the sale of a 50 percent interest in en*able, $3.7 million of gains from the sale of non-strategic gathering systems, $4.5 million of equity financing costs associated with the Pony Express Pipeline and $4.0 million of other miscellaneous income items.
The increase in "Interest Expense, Net" in 1997, relative to 1996, was the result of additional long-term debt issued in 1997 and higher levels of short-term debt, principally to fund capital expenditures. The increase in net expenses associated with "Minority Interests" in 1997 was primarily due to the dividend requirements associated with the $100 million of Capital Trust Securities issued in April 1997. The change in "Other, Net" from 1996 to 1997 was principally due to the items recorded in 1997 as described preceding.
The $2.6 million net increase in income tax expense from 1997 to 1998 reflected a decrease of approximately $4.7 million attributable to a decrease in 1998 pre-tax income and an increase of approximately $7.3 million attributable to an increase in the 1998 effective tax rate. This increased 1998 effective tax rate was principally due to (i) certain 1997 adjustments as described following and (ii) an increase in the 1998 effective state tax rate attributable to the addition of the results of operations of MidCon.
The $0.2 million net decrease in income tax expense from 1996 to 1997 reflected an increase of approximately $4.8 million attributable to an increase in 1997 pre-tax income and a decrease of approximately $5.0 million attributable to a decrease in the 1997 effective tax rate, principally due to the successful resolution of certain issues from prior years' federal income tax filings.
LIQUIDITY AND CAPITAL RESOURCES
The following table illustrates the sources of the Company's invested capital. The balances at December 31, 1998, reflect the incremental capital associated with the acquisition of MidCon, including the post-acquisition refinancings completed in 1998 (see Notes 2 (D) and 7 to the accompanying consolidated financial statements).
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(1) Includes the $1,394,846 Substitute Note assumed in conjunction with the acquisition of MidCon. This note was repaid on January 4, 1999. (2) If the government securities held as collateral were offset against the related debt, the ratio of total debt to invested capital at December 31, 1998, would be 72.3 percent.
The following discussion of cash flows should be read in conjunction with the accompanying Consolidated Statements of Cash Flows and related supplemental disclosures.
Net Cash Flows From Operating Activities
"Net Cash Flows From Operating Activities" decreased from $97.5 million in 1997 to $95.3 million in 1998, a decrease of $2.2 million or 2.3 percent. This decrease was principally attributable to the net impact of (i) an increase of approximately $65.5 million in cash used to increase net working capital in 1998, largely due to the net use of cash resulting from the changes in accounts receivable and accounts payable, (ii) the increase in earnings before non-cash charges and credits for 1998, (iii) increased 1998 cash used for gas in underground storage and (iv) the 1998 receipt of $27.5 million in settlement of a gas contract.
"Net Cash Flows From Operating Activities" increased from $75.6 million in 1996 to $97.5 million in 1997, an increase of $21.9 million. This increase was principally attributable to the same factors resulting in the reported increase in earnings between these years.
Net Cash Flows From Investing Activities
"Net Cash Flows Used in Investing Activities" increased from $496.6 million in 1997 to $3.5 billion in 1998, an increase of approximately $3.0 billion, principally due to (i) the $2.2 billion of net cash paid in 1998 and (ii) the net use of cash for the purchases of approximately $1.1 billion of U.S. government securities as collateral for the Substitute Note, in each case in conjunction with the acquisition of MidCon. In addition, cash outflows for
acquisitions other than MidCon were approximately $104.5 million less in 1998 than in 1997 and proceeds from sales of facilities increased by approximately $55.2 million in 1998.
"Net Cash Flows Used in Investing Activities" increased from $257.3 million in 1996 to $496.6 million in 1997, an increase of $239.3 million principally due to (i) the 1997 completion of the Pony Express Pipeline and construction of transmission laterals into the Kansas City metropolitan area, (ii) the acquisition of the Bushton facilities in April 1997 and (iii) the acquisition of an interest in the Red Cedar Gathering Company, also in December 1997.
Net Cash Flows From Financing Activities
"Net Cash Flows From Financing Activities" increased from $411.2 million in 1997 to approximately $3.4 billion in 1998, an increase of approximately $3.0 billion. This increase reflected reduced 1998 cash from short-term borrowings and the 1998 receipt of (i) $2.75 billion from the public sale of debt securities, (ii) $650 million from the public sale of common stock and (iii) $175 million from the public sale of Capital Trust Securities (in each case representing the refinancing of acquisition debt associated with the purchase of MidCon), net of associated issuance costs of approximately $78.2 million (see Note 7 to the accompanying consolidated financial statements). In addition, 1998 cash used for dividends and long-term debt retirement increased by $17.3 million and $8.0 million, respectively.
In March 1998, K N issued 12.5 million shares (18.75 million shares after adjustment for the December 1998 three-for-two stock split) of common stock in an underwritten public offering, receiving net proceeds of approximately $624.6 million. Also in March 1998, K N issued $2.35 billion principal amount of debt securities of varying maturities and interest rates in an underwritten public offering, receiving net proceeds of approximately $2.34 billion. The net proceeds from these two offerings were used to refinance borrowings under the MidCon acquisition financing arrangements and to purchase U.S. government securities to collateralize a portion of the Substitute Note. In April 1998, K N sold $175 million of 7.63% Capital Securities due April 15, 2028, in an underwritten offering, with the net proceeds of $173.1 million used to purchase U.S. government securities to further collateralize the Substitute Note. In November 1998, K N completed the concurrent underwritten public offerings of $400 million of 3-year senior notes and $460 million principal amount of premium equity participating security units ("PEPS"). The $397.4 million of net proceeds from the senior notes offering were used to retire a portion of K N's then-outstanding short-term borrowings. The proceeds from the PEPS offering was used to purchase U.S. treasury securities on behalf of the PEPS owners, which securities are the property of the PEPS owners and will be held as collateral to fund the obligation of the PEPS holders to purchase K N common stock at the end of a three-year period. For additional information on each of these financings, including terms of the specific securities and the associated accounting treatment, see Note 7 to the accompanying consolidated financial statements.
"Net Cash Flows From Financing Activities" increased from $177.8 million in 1996 to $411.2 million in 1997, an increase of approximately $233.4 million. This increase was principally attributable to (i) additional long-term debt issued in 1997, (ii) the issuance of $100 million of Capital Trust Securities in April 1997 and (iii) net increases in short-term borrowing in 1997. These increases were partially offset by decreased 1997 cash from the issuance of common stock.
On January 4, 1999, K N repaid the $1.4 billion Substitute Note payable to Occidental Petroleum as part of the MidCon acquisition. The note was repaid using the proceeds of approximately $1.1 billion from the sale of U.S. government securities which had been held as collateral, with the balance of the funds provided by an increase in short-term borrowings.
The Company's principal sources of short-term liquidity are its $1 billion revolving bank facilities (see Note 7 to the accompanying consolidated financial statements). At December 31, 1998, the Company had $297.0 million of commercial paper issued and outstanding (which is backed by the bank facilities). At February 17, 1999, short-term borrowings had increased to approximately $593 million, principally due to funds borrowed in conjunction with repayment of the Substitute Note as described preceding. The bank facilities include covenants which are common in such arrangements, including requirements that (i) the ratio of the Company's total debt to total capitalization not exceed 74 percent initially (upon issuance of common stock to the holders of the PEPS at the maturity thereof, the ratio will be reduced to 67 percent) and (ii) the Company's consolidated net worth (inclusive of trust preferred securities) be at least equal to the sum of $1.236 billion plus 50 percent of consolidated net income earned for each fiscal quarter ending after December 30, 1998.
Certain of the Company's operating lease arrangements provide that, in the event that the rating of K N's senior debt is lowered below investment grade by both of the two major rating agencies, the Company would be required to post letters of credit in support of its remaining lease payments. Although the Company currently has no information to indicate that such downgrades will occur, given the Company's current level of borrowing and utilization of its letter of credit facility, the posting of these additional letters of credit in support of lease obligations would place the Company in default under the terms of its revolving credit facility. The Company currently believes that, should such a default occur, it could obtain a waiver of the applicable default provisions or modification of such provisions to allow the facility to remain in place, although the pricing would likely increase.
Capital Expenditures and Commitments
Capital expenditures decreased from $311.1 million in 1997 to $256.5 million in 1998. This decrease was due principally to the fact that 1997 capital expenditures included the costs for completion of the Pony Express Pipeline and associated transmission laterals. The 1999 capital expenditure budget totals approximately $160 million. Approximately $44.3 million of this amount had been committed for the purchase of plant and equipment at December 31, 1998.
Principal acquisitions or investments made during 1998 included the MidCon and Thermo acquisitions and the pressure reduction program in the Hugoton basin. Major asset sales during 1998 included the sale of the Company's Kansas natural gas distribution properties, certain microwave towers and certain under-performing natural gas gathering and processing facilities. See Note 2 to the accompanying consolidated financial statements for more information on these acquisitions, investments and sales.
COMMON STOCK SPLIT AND DIVIDEND ACTION
On November 9, 1998, the Board of Directors of K N Energy, Inc. approved a 7.1 percent increase in the quarterly dividend and a three-for-two split of the Company's common stock. The regular quarterly dividend was declared at $0.30 per common share, an increase from $0.28 per common share. Giving effect to the stock split, the quarterly dividend is $0.20 per common share. The stock split was distributed and the increase in dividend was paid concurrently on December 31, 1998, to shareholders of record at the close of business on December 15, 1998.
REGULATION
On January 23, 1998, K N Interstate Gas Transmission Co. ("KNI") filed a general rate case with the Federal Energy Regulatory Commission ("FERC") requesting a $30.2 million increase in annual revenues. As a result of FERC action, KNI was allowed to place its rates into effect on August 1, 1998, subject to refund, and KNI has recorded provisions
for refund based on its expectation of ultimate resolution. KNI is currently following the procedural schedule established for the rate case and a hearing on its proposed rates is currently scheduled to commence on July 20, 1999.
On December 29, 1998, Rocky Mountain Natural Gas Company ("RMNG"), a wholly owned subsidiary of K N Energy, Inc., received a "show cause" order from the Colorado Public Utilities Commission (the "Commission"). The Commission has concluded that there is reason to believe that RMNG's rates may be excessive and has ordered further investigation. A procedural schedule has been established and a hearing is scheduled to commence on June 1, 1999.
RISK MANAGEMENT
To minimize the risk of price changes in the natural gas and NGLs markets, the Company uses certain financial instruments for hedging purposes. These instruments include energy products traded on the New York Mercantile Exchange, the Kansas City Board of Trade and over-the-counter markets including, but not limited to, futures and options contracts and fixed-price swaps. The Company is exposed to credit-related losses in the event of nonperformance by counterparties to these financial instruments, but does not expect any counterparties to fail to meet their obligations given their existing credit ratings.
Pursuant to a policy approved by its Board of Directors, the Company is to engage in these activities only as a hedging mechanism against price volatility associated with pre-existing or anticipated physical gas and condensate sales, gas purchases, system use and storage in order to protect profit margins, and is not to engage in speculative trading. Commodity-related activities of the risk management group are monitored by the Company's Risk Management Committee, which is charged with the review and enforcement of the Board of Directors' risk management policy. The Risk Management Committee reviews the types of hedging instruments used, contract limits and approval levels and may review the pricing and hedging of any or all commodity transactions. All energy futures, swaps and options are recorded at fair value. The fair value of these risk management instruments reflects the estimated amounts that the Company would receive or pay to terminate the contracts at the reporting date, thereby taking into account the current unrealized gains or losses on open contracts. Market quotes are available for substantially all financial instruments used by the Company. Gains and losses on hedging positions are deferred and recognized as gas purchases expense in the periods in which the underlying physical transactions occur.
The Company measures the risk of price changes in the natural gas and NGLs markets utilizing a Value-at-Risk ("VAR") model. VAR is a statistical measure of how much the marked-to-market value of a portfolio could change during a period of time, within a certain level of statistical confidence. The Company utilizes a closed form model to evaluate risk on a daily basis. The VAR computations utilize a confidence level of 97.7 percent for the resultant price movement and a holding period of one day chosen for the calculation. The confidence level used means that there is a 97.7 percent probability that the mark-to-market losses for a single day will not exceed the VAR number presented. Instruments evaluated by the model include forward physical gas, storage and transportation contracts and financial products including commodity futures and options contracts, fixed price swaps, basis swaps and over-the-counter options. VAR at December 31, 1998, was $5.8 million and averaged $4.6 million for 1998.
The Company's calculated VAR exposure represents an estimate of the reasonably possible net losses that would be recognized on the Company's portfolio of derivatives assuming hypothetical movements in future market rates, and is not necessarily indicative of actual results that may occur. It does not represent the maximum possible loss or any expected loss that may occur, since actual future gains and losses will differ from those estimated. Actual gains and losses may differ from estimates due to actual fluctuations in market rates, operating exposures and the timing thereof, as well as changes in the Company's portfolio of derivatives during the year.
The Company's Treasury Department manages the Company's interest rate exposure, utilizing interest rate swaps, caps or similar derivatives within Board-established policy. None of these interest rate derivatives is leveraged. The Company currently is not hedging its interest rate exposure resulting from its short-term borrowings. The market risk related to short-term borrowings from a one percent change in interest rates would result in an approximate $5.9 million impact on pre-tax income, based on current short-term borrowing levels.
There are recently issued accounting pronouncements that change the accounting and reporting requirements for certain risk management activities (see Note 9 to the accompanying consolidated financial statements).
OUTLOOK/FORWARD-LOOKING INFORMATION
General
Certain information contained herein may include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Although the Company believes that these statements are based upon reasonable assumptions, it can give no assurance that its goals will be achieved. Important factors that could cause actual results to differ materially from those in the forward-looking statements contained herein include, among other factors, the pace of deregulation of retail natural gas and electricity markets in the United States, federal, state and international regulatory developments, the timing and extent of changes in commodity prices for oil, natural gas, NGLs, electricity, certain agricultural products and interest rates, the extent of success in acquiring natural gas facilities, the timing and success of efforts to develop power, pipeline and other projects, political developments in foreign countries, weather-related factors and conditions of capital markets and equity markets during the periods covered by the forward-looking statements. All of these factors are difficult to predict and many are beyond the Company's control.
Readiness for Year 2000
The following is a discussion of the Year 2000 problem and its potential impact on the Company. The Securities and Exchange Commission ("SEC") has issued specific guidelines for public companies regarding their disclosure of the Year 2000 problem. The guidelines require more detailed disclosure of each company's analysis of and approach to the Year 2000 problem. As a result, the Company is providing the following disclosure; however, the length and detail contained in this disclosure, relative to the other disclosures contained herein, is not an indication of the Company's view of the relative risk of the Year 2000 problem to the Company.
Some computers and programs, and some devices containing computer chips ("embedded chips") store or process dates containing the Year 2000 as "00." This can result in inaccurate date-related calculations. It is expected that once the Year 2000 arrives, computers, computer programs and devices with embedded chips that have not been modified to correct this problem will not function normally. The Company relies on a number of automated systems to conduct its operations and to transact its business, as is common among large diversified energy companies. In addition, certain of the Company's pipelines and processing equipment and related systems contain electric controls or other devices containing embedded chips. These controls may also be adversely affected by this problem.
In 1997, the Audit Committee of the Company's Board of Directors (the "Audit Committee") established a Year 2000 project to address the Year 2000 problem. In that year, the Company established a Year 2000 Executive Steering Committee (the "Year 2000 Committee") and a Year 2000 Project Management Office (the "Year 2000 Project Management Office"). The Year 2000 project is an ongoing effort monitored by the Audit Committee.
The Audit Committee has adopted a Year 2000 Plan (the "Plan") and will oversee its implementation by receiving periodic reports from the Year 2000 Committee and directly from management. The Audit Committee is prepared to require management to make additional efforts, including amending the Plan as necessary, to fulfill the Audit Committee's goal of taking reasonable steps to minimize injury to people, damage to property, disruption to the Company's delivery of products and services, supporting systems and business operations, and other risks associated with the Year 2000 problem.
The Year 2000 Committee is charged with directing the implementation of the Plan in accordance with resolutions of the Audit Committee and under the direction of the Company's designated senior executives. The Year 2000 Committee oversees the Year 2000 Project Management Office, headed by the Year 2000 Project Coordinator. The Year 2000 Committee keeps the Audit Committee informed of the Company's progress in implementing the Plan and of significant updates that are made to the Plan. The Year 2000 Committee communicates the Audit Committee's directives concerning the Plan to management and executives, and oversees the implementation of those directives.
The Year 2000 Project Management Office works closely with the Company's Readiness Teams comprised of members of the Company's operating units. The teams have been organized to further implement the Plan throughout the Company. The Project Management Office, among other things, promotes exchange of information about Year 2000 problems and solutions, assists in disseminating information about the Company's policies governing communications concerning Year 2000 issues and serves as a conduit between the various Readiness Teams and the Year 2000 Committee.
The aim of the Plan is to take reasonable steps to prevent the Company's mission critical functions from being impaired due to the Year 2000 problem. "Mission critical" describes those systems, devices, functions and external entities that are of material importance to maintaining the Company's capacity to deliver and account for products and services without interruption, and to maintain the Company's supporting business operations with no material disruption or diminution in quality.
Each of the Company's operating units is in various stages of implementing the Plan to address the Year 2000 problem. These efforts include:
o an assessment of potential problems; o an inventory of systems and areas which may need to be corrected; o remediation and implementation, with priority given to mission critical items; o the testing of such systems and devices; and o developing contingency plans in case the Company cannot correct the problem in time, or in the event certain facets of the Year 2000 problem go undetected or do not manifest themselves until after January 1, 2000.
Specifically, the Company is in the process of correcting programmable code, replacing non-Year 2000-ready embedded chips, installing Year 2000-ready releases of certain vendor-supplied computer systems and, in some cases, replacing existing systems with new internally or externally developed software in advance of December 31, 1999.
The Company has completed an inventory of affected items in the non-information technology area and is assessing the results. The Company has begun testing and currently has found very few items that are likely to suffer adverse effects from the Year 2000 problem. The Company expects testing and remediation of mission critical items to be substantially completed by mid-1999.
For the Company's Plan to be successful, the Company must rely for some purposes on outside contractors. There is a risk that those contractors will not complete their work prior to the Year 2000. The Company is developing alternative ways to conduct its business if such deadlines are not met. However, any alternative may involve additional expense and may not be implemented in time to avoid the Year 2000 problem. Ultimately, these alternatives may not be successful.
The Company also relies on suppliers, business partners and other external entities which may or may not be addressing their own problems associated with the Year 2000 problem. The Company has sent out questionnaires to external entities to determine what steps they have taken to correct any Year 2000 problems they may have. The Company has no control over such external entities' efforts, so the Company has developed contingency plans in case such external entities do not complete their efforts before the Year 2000.
The Company estimates that the direct costs the Company has incurred or will incur in 1998, 1999 and 2000 associated with assessing, inventorying, remediating and testing internally developed computer applications, hardware and equipment, including embedded chip systems and third-party developed software, to be between $5 million and $7 million. In addition, as part of the integration of the Company's systems with the systems of MidCon, the Company has begun modifying certain of its computer systems for the combined company or purchasing computer systems from third parties. These computer systems will address the Year 2000 problem and are expected to be operational prior to December 31, 1999. The costs for these computer systems are expected to be between $23 million and $25 million, the majority of which will be capitalized.
The SEC's guidelines also require the Company to address the most reasonably likely worst case scenarios resulting from the Year 2000 problem. As a result of the Year 2000 problem, the Company may be faced with: failure of electrical, gas and similar services and supplies from utilities, disruption of telecommunications facilities, interruptions in the nation's transportation systems and failure of a substantial number of the Company's mission critical hardware and software systems. In addition, the Company's key suppliers or customers may experience their own Year 2000 problems in a way that materially adversely affects the Company's ability to do business without interruption or disruption. As a result of the cumulative impact of these events, the Company's business may be materially adversely affected. The adverse impact of these events occurring can not be quantified at this time.
The Company is in the process of developing contingency plans to address issues associated with the reasonably likely worst case scenarios. The Company expects to have such contingency plans substantially completed by the end of June 1999. The Company will then refine and update its contingency plans for the remainder of 1999.
The Company does not believe that the direct costs associated with the Year 2000 problem will be material to its business, financial position or results of operations.
Litigation and Environmental
The Company's anticipated environmental capital costs and expenses for 1999, including expected costs for voluntary remediation efforts, are approximately $8.4 million. A substantial portion of the Company's environmental costs are either recoverable through insurance and indemnification provisions or have previously recorded liabilities associated with them.
Refer to Notes 4(A) and 4(B) to the accompanying consolidated financial statements for additional information on the Company's pending litigation and environmental matters. The Company believes it has established adequate reserves such that the resolution of pending litigation and environmental matters will not have a material adverse impact on the Company's business, financial position or results of operations.
New Business Venture
With its 1998 Thermo acquisition (see Note 2 (B) to the accompanying consolidated financial statements), the Company obtained its first electric generation assets. In addition, the Company has announced plans to participate in the investment of $2.5 billion over the next three to five years to build gas-fired electric generation plants. The Company plans to obtain a significant amount of non-recourse financing and partner with electricity companies to build plants totaling 5,000 megawatts of electric generation capacity along its current natural gas pipeline systems.
Significant Operating Variables
The Company's principal exposure to price variability is with NGLs processing margins. The Company attempts to mitigate this exposure by an appropriate mix of "percent of proceeds," "keep whole" and "fee based" processing agreements and by the use of financial hedging instruments (see "Risk Management," elsewhere herein). Under current agreements with producers, a one cent change in average processing margins affects pre-tax operating income by approximately $5.5 million.
The Company also has exposure to variation in natural gas prices and basis differentials, which can affect gross margins in its Midstream sales, transportation and storage and Downstream retail and marketing businesses. Basis differential is a term that refers to the difference in natural gas prices between two locations or two points in time. These price differences can be affected by, among other things, natural gas supply and demand, available transportation capacity, storage inventories and deliverability, prices of alternative fuels and weather conditions. In December 1998, the Northern Border Pipeline began operations on its 700 million cubic feet per day ("cfd") expansion project from Canadian supply areas into the Chicago market area, which is the terminus of NGPL's main pipeline system. In addition, the Alliance Pipeline, a joint venture of several energy companies, is currently planning a 1.3 billion cfd pipeline to transport natural gas from Canada into the Chicago market area. The in-service date for the Alliance pipeline is uncertain but may be between late 2000 and 2002. In addition, various pipelines have proposed projects to take gas out of the Chicago area to market areas in the Northeast United States. It is currently unknown what impact, if any, this additional pipeline capacity will have on gas prices and basis differentials for delivery points in the upper Midwest.
ITEM 8:
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To K N Energy, Inc.:
We have audited the accompanying consolidated balance sheets of K N Energy, Inc. (a Kansas corporation) and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, comprehensive income, common stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of K N Energy, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index of financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
/s/ Arthur Andersen LLP
Denver, Colorado February 2, 1999
CONSOLIDATED STATEMENTS OF INCOME K N ENERGY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
The accompanying notes are an integral part of these statements.
CONSOLIDATED BALANCE SHEETS K N ENERGY, INC. AND SUBSIDIARIES
The accompanying notes are an integral part of these statements.
CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDERS' EQUITY K N ENERGY, INC. AND SUBSIDIARIES
The accompanying notes are an integral part of these statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS K N ENERGY, INC. AND SUBSIDIARIES
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
The accompanying notes are an integral part of these statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Event Subsequent to Date of Auditors' Report (Unaudited)
On February 22, 1999, Sempra Energy ("Sempra") and the Company announced that their respective boards of directors had unanimously approved a definitive agreement (the "Agreement") under which Sempra and the Company would combine in a stock-and-cash transaction valued in the aggregate at $6.0 billion. Sempra is an energy services holding company based in San Diego, California, serving 21 million customers through natural gas and electric distribution, as well as a broad range of energy-related products and services throughout the United States, Canada, Mexico and other countries in Latin America. Under the terms of the Agreement, Sempra will acquire all of the Company's outstanding common shares (the "K N Shares") for a combination of shares of Sempra common stock (the "Sempra Shares") and cash as described following. The Company's shareholders will have the option to elect to receive for each of their K N Shares either (i) .7805 Sempra Shares plus $7.50, (ii) 1.115 Sempra Shares or (iii) $25.00, subject to pro-ration, such that 70 percent of the K N Shares will be converted into Sempra Shares and 30 percent of the K N Shares will be converted into cash. This merger is conditioned, among other things, upon the approvals of shareholders of both companies, the Federal Energy Regulatory Commission and the state commissions of Colorado and Wyoming and clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. Closing is currently expected in six to eight months.
(A) Nature of Operations
K N Energy, Inc., referred to herein together with its consolidated subsidiaries as "K N" or the "Company," is an energy services provider and has operations in 16 states in the Rocky Mountain and Mid-Continent regions, with principal operations in Arkansas, Colorado, Illinois, Iowa, Kansas, Nebraska, Oklahoma, Texas and Wyoming. The Company also owns a natural gas distribution system in the Mexican state of Sonora. During 1998, the Company made significant acquisitions (see Note 2). Energy services include: gathering, processing, storing, transporting and marketing natural gas, providing retail natural gas distribution services, providing field services to natural gas producers, marketing natural gas liquids ("NGLs"), and generating and selling electricity. The Company has both regulated and nonregulated operations.
(B) Basis of Presentation
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported amounts of revenues and expenses. Actual results could differ from these estimates.
The consolidated financial statements include the accounts of K N Energy, Inc. and its majority-owned subsidiaries. Investments in jointly owned operations in which the Company has 20 to 50 percent ownership are accounted for under the equity method. All material intercompany transactions and balances have been eliminated. Certain prior year amounts have been reclassified to conform to the current presentation.
(C) Accounting for Regulatory Activities
The Company's regulated public utilities are accounted for in accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 71, Accounting for the Effects of Certain Types of Regulation, which prescribes
the circumstances in which the application of generally accepted accounting principles is affected by the economic effects of regulation.
Regulatory assets and liabilities represent probable future revenues or expenses to the Company associated with certain charges and credits which will be recovered from or refunded to customers through the ratemaking process. The following regulatory assets and liabilities are reflected in the accompanying Consolidated Balance Sheets:
As of December 31, 1998, $48.6 million of the Company's regulatory assets and $56.1 million of the Company's regulatory liabilities were being recovered from or refunded to customers through rates over periods ranging from 1 to 15 years. Approximately $7.4 million of the regulatory assets at December 31, 1998, have been included in rates subject to refund, pending the outcome of a current rate case. Approximately $3.0 million of the Company's regulatory assets at December 31, 1998, are included in rate base and are earning a return on investment.
(D) Revenue Recognition Policies
In general, the Company recognizes revenues as services are rendered or goods are delivered. The Company's rate-regulated retail natural gas distribution business bills customers on a monthly cycle billing basis. Revenues are recorded on an accrual basis, including an estimate for gas delivered but unbilled at the end of each accounting period.
(E) Earnings Per Share
Basic earnings per share is computed based on the monthly weighted-average number of common shares outstanding during each period. The weighted-average number of common shares used in computing basic earnings per share was 64,021,000 for 1998, 46,588,500 for 1997 and 43,653,000 for 1996. Diluted earnings per share is computed based on the monthly weighted-average number of common shares outstanding during the periods and the assumed exercise or conversion of securities convertible into common stock for which the effect of conversion or exercise would be dilutive (stock options and warrants) using the treasury stock method. Dilutive securities assumed to have been converted or exercised totaled 614,500 for 1998, 718,500 for 1997 and 783,000 for 1996. Weighted-average shares outstanding and all per share amounts in the accompanying consolidated financial statements and these notes have been restated to reflect a three-for-two split of the Company's common stock (see Note 7 (D)).
(F) Restricted Deposits
The Company uses energy financial instruments to reduce its exposure to price risk related to natural gas and NGLs. Restricted Deposits consist of monies on deposit with brokers that are restricted to meet exchange trading requirements (see Note 9).
(G) Inventories
Inventories are accounted for using the following methods, with the percent of the total dollars at December 31, 1998, shown in parentheses: average cost (91.1%), last-in, first-out (8.3%) and first-in, first-out (0.6%). All non-utility inventories held for resale are valued at the lower of cost or market.
The Company also maintains gas in its underground storage facilities on behalf of certain third parties. The Company receives a fee for its storage services but does not reflect the value of gas stored for third parties in the accompanying consolidated financial statements.
(H) Investments
Investments consist primarily of equity method investments in unconsolidated subsidiaries and joint ventures, and include ownership interests in net profits and net cash flows. In addition, the Company has an investment in Tom Brown, Inc. ("TBI") common and convertible preferred stock. Equity in earnings of investments accounted for under the equity method totaling $21.7 million and $3.9 million for 1998 and 1997, respectively, are included in operating revenues (within the appropriate business segment) in the accompanying Consolidated Statements of Income.
(I) Property, Plant and Equipment
Property, plant and equipment is stated at historical cost, which, for constructed plant, includes indirect costs such as payroll taxes, fringe benefits, administrative and general costs. Expenditures that increase capacities, improve efficiencies or extend useful lives are capitalized. Routine maintenance, repairs and renewal costs are expensed as incurred.
The cost of normal retirements of depreciable utility property, plant and equipment, plus the cost of removal less salvage, is deducted from accumulated depreciation with no effect on current period earnings. Gains or losses are recognized upon retirement of non-utility property, plant and equipment, and utility property, plant and equipment constituting an operating unit or system, when sold or abandoned.
In accordance with the provisions of SFAS 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, the Company reviews the carrying values of its long-lived assets whenever events or changes in circumstances indicate that such carrying values may not be recoverable. As yet, no asset or group of assets has been identified for which the sum of expected future cash flows (undiscounted and without interest charges) is less than the carrying amount of the asset(s) and, accordingly, no impairment losses have been
recorded. However, currently unforeseen events and changes in circumstances could require the recognition of impairment losses at some future date.
(J) Depreciation and Amortization
Depreciation is computed based on the straight-line method over the estimated useful lives of assets, ranging from 3 to 40 years for each of the Upstream, Midstream and Downstream segments.
(K) Interest Expense, Net
"Interest Expense, Net" as presented in the accompanying Consolidated Statements of Income is net of (i) the debt component of the allowance for funds used during construction ("AFUDC - Interest") and (ii) interest income related to government securities (collectively, "Interest Income"), as shown in the following table:
As discussed in Note 2, in conjunction with the January 30, 1998, acquisition of MidCon Corp., the Company was required by the definitive stock purchase agreement to assume the Substitute Note for $1.4 billion and to collateralize the Substitute Note with bank letters of credit, a portfolio of government securities or a combination of the two. As a result, the Company has a significant amount of interest income ($27.4 million representing cash received during 1998) associated with the issuance of the Substitute Note, which has been reported together with the related interest expense as described preceding.
(L) Cash Flow Information
The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. "Other, Net," presented as a component of "Net Cash Flows From Operating Activities" in the accompanying Consolidated Statements of Cash Flows includes, among other things, the amortization of the gas plant acquisition adjustment recorded in conjunction with the acquisition of MidCon, undistributed equity in earnings of unconsolidated subsidiaries and joint ventures and other non-cash charges and credits to income.
CHANGES IN OTHER WORKING CAPITAL ITEMS (NET OF ACQUISITION AND DISPOSITION EFFECTS) INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
* See Note 1 (K).
During 1998, the Company acquired MidCon Corp. and interests in assets from the Thermo Companies in transactions that included both cash and non-cash components. In December 1997, the Company acquired Interenergy Corporation in a largely non-cash transaction. For additional information on these transactions, see Note 2.
(M) Accounts Receivable
The caption "Accounts Receivable" in the accompanying Consolidated Balance Sheets is presented net of allowances for doubtful accounts of $10.8 million and $1.7 million at December 31, 1998 and 1997, respectively.
2. ACQUISITIONS, INVESTMENTS AND SALES
(A) Sale of Microwave Facilities
In September 1998, the Company sold certain of its microwave towers and associated land and equipment to Boston-based American Tower Corp. for $14.6 million. The sale resulted in a pre-tax gain of $10.9 million ($6.7 million after tax or $0.10 per diluted share) included in the accompanying Consolidated Statements of Income under the caption "Other, Net."
(B) Thermo Companies
During the third quarter of 1998, the Company completed its acquisition of interests in four independent power plants in Colorado from the Denver-based Thermo Companies ("Thermo"), representing approximately 380 megawatts of electric generation capacity and access to approximately 130 Bcf of natural gas reserves. These generating facilities are located in Ft. Lupton, Colorado (272 megawatts) and Greeley, Colorado (108 megawatts) and sell their power output to Public Service Company of Colorado under long-term agreements. Payment for these interests will be made over a two-year period, with the initial payment of 689,810 shares (not adjusted for the December 1998 three-for-two stock split) of K N common stock having been made on October 21, 1998. The second installment payment was made on January 4, 1999, consisting of 833,623 shares of K N common stock and $15 million in cash. The remaining payments (in 1999 and 2000) will be made in a combination of cash and common stock as agreed to by the Company and Thermo, with the default mix being 50 percent stock and 50 percent cash. In conjunction with this transaction accounted for as a purchase, at December 31, 1998, K N had recorded a current liability of $86.8 million (shown in the accompanying Consolidated Balance Sheets as "Payable for Purchase of Thermo Companies") and a long-term liability of $31.4 million (included in the accompanying Consolidated Balance Sheets within the caption "Other" under the heading "Other Liabilities and Deferred Credits") representing the remaining purchase obligation. The Company's investment in Thermo is shown in the accompanying Consolidated Balance Sheets at December 31, 1998, under "Investments" ($67.3 million) and "Deferred Charges and Other Assets" ($79.9 million), with the majority of the remaining balance shown as additions to "Property, Plant and Equipment," and lesser amounts included with other asset and liability accounts.
(C) Sale of Kansas Distribution Properties
In March 1998, the Company completed the sale of its Kansas retail natural gas distribution properties, located in 58 Kansas communities and serving approximately 30,000 residential, commercial and industrial customers, to Midwest Energy, Inc., a customer-owned cooperative based in Hays, Kansas. The Company received approximately $24 million in cash in conjunction with the sale and recorded a pre-tax gain of approximately $8.5 million (approximately $5.2 million after tax or $0.08 per diluted share). Concurrently with the sale, the Company received $27.5 million in cash in exchange for the release of the purchaser from certain contractual gas purchase obligations, which amount will be amortized as an offset to expense over a period of years as the associated volumes are sold.
(D) MidCon Corp.
On January 30, 1998, pursuant to a definitive stock purchase agreement (the "Agreement"), the Company acquired all of the outstanding shares of capital stock of MidCon Corp. ("MidCon") from Occidental Petroleum Corporation ("Occidental") for $2.1 billion in cash and the assumption of a $1.4 billion note (the "Substitute Note"), at which time MidCon became a wholly owned subsidiary of K N Energy, Inc. (the "Acquisition"). The Substitute Note bore interest at 5.798 percent, was repaid January 4, 1999, and was required to be collateralized by U.S. government securities, letters of credit or a combination of the two. In conjunction with the Acquisition, the Company also assumed MidCon's obligation to lease the MidCon Texas intrastate pipeline system under a 30-year operating lease, requiring average annual lease payments of approximately $30 million. The Acquisition was initially financed through a combination of credit agreements (see Note 7).
MidCon is engaged in the purchase, gathering, processing, transmission, storage and sale of natural gas to utilities, municipalities, and industrial and commercial users. MidCon's pipeline system includes over 13,000 miles of natural gas pipelines located in the center of the North American pipeline grid, with access to major supply and market areas. MidCon is also one of the nation's largest natural gas storage operators and owns and operates several natural gas gathering and natural gas processing facilities.
The Acquisition was accounted for as a purchase for accounting purposes and, accordingly, the MidCon assets acquired and liabilities assumed have been preliminarily recorded at their respective estimated fair market values as of the acquisition date. The final fair market values will be assigned after completion of the review of the relevant assets, liabilities and issues identified as of the acquisition date. The preliminary allocation of purchase price has resulted in the recognition of a gas plant acquisition adjustment of approximately $3.9 billion, principally representing the excess of the assigned fair market value of the assets of Natural Gas Pipeline Company of America ("NGPL"), a wholly owned subsidiary of MidCon, over the historical cost for ratemaking purposes. This gas plant acquisition adjustment, none of which is currently being recognized for ratemaking purposes, is being amortized over 36 years, approximately the estimated remaining useful life of NGPL's interstate pipeline system. For the year ended December 31, 1998, approximately $97.9 million of such amortization was charged to expense. The assets, liabilities and results of operations of MidCon are included with those of the Company beginning with the January 30, 1998, acquisition date. Historical information for periods prior to January 30, 1998, does not reflect any impact associated with the MidCon acquisition.
The following pro forma information gives effect to the acquisition of MidCon as if the business combination had occurred at the beginning of each period presented. The pro forma adjustments which have been made are based on a preliminary allocation of the purchase price to assets acquired and liabilities assumed. In addition, no pro forma adjustments to prior periods have been made for the post-acquisition refinancings completed by K N. This unaudited pro forma information should be read in conjunction with the accompanying consolidated financial statements, Management's Discussion and Analysis of Financial Condition and Results of Operations and with
the unaudited pro forma consolidated financial statements and related notes previously filed with the Securities and Exchange Commission. This pro forma information is not necessarily indicative of the financial results which would have occurred had the Acquisition taken place on the dates indicated, nor is it necessarily indicative of future financial results.
(E) Red Cedar
In December 1997, the Company purchased an equity interest in Red Cedar Gathering Company ("Red Cedar"), a gathering system located in the northern San Juan Basin on the Southern Ute Indian Reservation in La Plata County, Colorado. K N owns a 49 percent interest, which is accounted for under the equity method. Red Cedar is jointly owned with the Southern Ute Indian Tribe. See Note 12 for information related to K N's corporate guarantee of Red Cedar debt.
(F) Interenergy
In December 1997, the Company acquired Interenergy Corporation ("Interenergy"), a diversified energy company providing natural gas gathering, processing and marketing services in the Rocky Mountain and Mid-Continent regions. In a transaction accounted for as a purchase, the Company exchanged 544,604 shares (not adjusted for the December 1998 three-for-two stock split) of K N common stock for all of the outstanding shares of Interenergy.
(G) Bushton
In March 1997, the Company completed its purchase of several Enron Corporation subsidiaries that owned or operated the Bushton natural gas processing facility located in Ellsworth County, Kansas, and other Hugoton Basin gathering assets located in Kansas and Oklahoma. The Company assumed operation of these facilities effective April 1, 1997, and has accounted for this transaction as a purchase. The processing facilities at Bushton are subject to operating leases (which expire in 2012) requiring semi-annual payments averaging $23.1 million per year for the remaining term of the leases. Under certain conditions, the terms of these leases would require the posting of letters of credit (see Note 12).
(H) TransColorado Pipeline Project
After receiving required regulatory approvals, the TransColorado Gas Transmission Company ("TransColorado"), an enterprise jointly owned by K N and Questar Corp., began construction in July 1998 of a 280-mile-long natural gas pipeline project which includes two compressor stations and extends from near Rangely, Colorado, to its southern terminus at the Blanco Hub near Aztec, New Mexico. The pipeline is
expected to be completed and placed in service in early 1999 at a cost of approximately $280 million and have transmission capacity of approximately 300 million cubic feet of natural gas per day. On October 14, 1998, TransColorado entered into a $200 million revolving credit agreement with a group of commercial banks. See Note 12 for information related to K N's corporate guarantee of TransColorado debt.
3. REGULATORY MATTERS
(A) Rate Matters
On January 23, 1998, K N Interstate Gas Transmission Co. ("KNI") filed a general rate case with the Federal Energy Regulatory Commission ("FERC") requesting a $30.2 million increase in annual revenues. As a result of the FERC action, KNI was allowed to place its rates into effect on August 1, 1998, subject to refund, and provisions for refund have been recorded based on its expectation of ultimate resolution. KNI is currently following the procedural schedule established for the rate case, and a hearing on its proposed rates is currently scheduled to commence on July 20, 1999.
On December 29, 1998, Rocky Mountain Natural Gas Company ("RMNG"), a wholly owned subsidiary of K N Energy, Inc. received a "show cause" order from the Colorado Public Utilities Commission (the "Commission"). The Commission has concluded that there is reason to believe that RMNG's rates may be excessive and may require further investigation. A procedural schedule has been established and a hearing is scheduled to commence on June 1, 1999.
(B) Retail Unbundling
In November 1997, the Company announced a plan to give residential and small commercial customers in Nebraska a choice of natural gas suppliers. This program, the Nebraska Choice Gas program, became effective June 1, 1998. This program separates, or "unbundles," the natural gas purchases from other utility services. As of December 31, 1998, the plan had been approved by 176 communities, representing approximately 95,000 customers served by the Company in Nebraska. In June 1996, after receiving Wyoming Public Service Commission approval for a pilot program, the Company implemented a similar plan for approximately 10,500 residential and commercial customers in 10 Wyoming communities.
4. ENVIRONMENTAL AND LEGAL MATTERS
(A) Environmental Matters
The U.S. Environmental Protection Agency (the "EPA") recently published a final rule addressing transport of ground level ozone. The rule affects 22 Eastern and Midwestern states, including Illinois and Missouri in which the Company operates gas compression facilities. The rule requires reductions in emissions of nitrogen oxide, a precursor to ozone formation, from various emission sources, including utility and non-utility sources. The rule requires that the affected states prepare and submit State Implementation Plans to the EPA by September 1999, reflecting how the required emissions reductions will be achieved. Emission controls are required to be installed by May 1, 2003. This rule will likely result in the Company, as well as its competitors, being required to install some form of new emissions control technology on certain equipment it operates. Another impact from the rule is that it may result in broad increased use of natural gas, as other sources of nitrogen oxide air emissions, including utilities, seek to achieve the reductions required under the rule. The State Implementation Plans which will effectuate this rule have yet to be proposed or promulgated, and will require detailed analysis before their final economic impact can be ascertained. While additional capital costs are likely to result from this rule, based on currently available information, the Company does not believe that these costs will have a material adverse effect on its business, financial position or results of operations.
On February 6, 1998, the EPA published in the Federal Register a proposed standard to limit emissions of hazardous air pollutants ("HAPs") from oil and natural gas production as well as from natural gas transmission and storage facilities. This is a Maximum Achievable Control Technology ("MACT") standard, and is mandated under section 112 of the 1990 Amendments to the Clean Air Act. The proposed MACT standard requires that the affected facilities reduce emissions of HAPs by 95 percent. This new standard will require the Company to achieve this reduction either by process modifications or by installing new emissions control technology. The MACT standard will affect the Company and its competitors in a like manner. The EPA has stated that the standard will be promulgated in its final form by May 15, 1999. The rule will allow most affected sources three years to come into compliance. The rule in its final form will require detailed analysis to determine its overall effect on the Company. While additional capital costs are likely to result from this rule, the Company believes that the rule will not have a material adverse effect on the Company's business, financial position or results of operations.
In connection with the Company's acquisition of MidCon in January 1998, Occidental indemnified the Company against certain liabilities, including litigation and the failure of MidCon to be in compliance with applicable laws, which, in each case, would have a material adverse effect on MidCon, for one year following the closing date. To the extent that an environmental liability of MidCon is not covered by Occidental's indemnity obligation or, to the extent that matters arise following the termination of Occidental's indemnification obligation, the Company will be responsible for MidCon's environmental liabilities. The Company does not expect that such costs will have a material adverse effect on its business, financial position or results of operations.
Pursuant to certain acquisition agreements involving Cabot Corporation ("Cabot"), Cabot indemnified the Company for certain environmental liabilities associated with assets in Texas, Oklahoma and New Mexico acquired from American Oil and Gas Corporation. Issues arose concerning Cabot's indemnification obligations, and the Company and Cabot entered into binding arbitration to resolve all issues in dispute. The binding decision of the arbitrators resulted in the requirement that Cabot pay the Company for a substantial portion of past and future environmental related costs associated with the properties. In December 1998, the Company recorded a charge of approximately $7.2 million representing both previously incurred costs which were not awarded in the arbitration and the recognition of a liability for the Company's share of estimated future costs. As a result of this settlement, the Company will have no future expense associated with this matter. The Company does not expect its potential exposure for the remaining liabilities to have a material adverse effect on the Company's business, financial position or results of operations.
Based on current information and taking into account reserves established for environmental matters, the Company does not believe that compliance with federal, state and local environmental laws and regulations will have a material adverse effect on the Company's business, financial position or results of operations. In addition, the clean-up programs in which the Company is engaged are not expected to interrupt or diminish the Company's operational ability to gather or transport natural gas. However, there can be no assurances that future events, such as changes in existing laws, the promulgation of new laws, or the development of new facts or conditions will not cause the Company to incur significant costs.
(B) Litigation Matters
On October 9, 1992, Jack J. Grynberg filed suit in the United States District Court for the District of Colorado against the Company, RMNG and GASCO, Inc. (the "K N Entities") alleging that the K N Entities as well as K N Production Company and K N Gas Gathering, Inc., have violated federal and state antitrust laws. In essence, Grynberg asserts that the defendant companies have engaged in an illegal exercise of monopoly power, have illegally denied him economically feasible access to essential facilities to transport and distribute gas produced from fewer than 20 wells located in northwest Colorado, and have illegally attempted to monopolize or to
enhance or maintain an existing monopoly. Grynberg also asserts certain causes of action relating to a gas purchase contract. In February 1999, the Federal District Court granted summary judgment regarding some of Grynberg's antitrust and state law claims, while allowing other claims to proceed to trial. The Company's potential liability and the amount of such damages, if any, are subject to dispute between the parties; however, the Company believes it has a meritorious position in these matters and does not expect this lawsuit to have a material adverse effect on the Company's business, financial position or results of operations. In July 1996, the U.S. District Court, District of Colorado lifted its stay and allowed discovery for a period of time. Currently, this case is still pending. Discovery is now complete, but no trial date has yet been set.
On July 26, 1996, the Company and RMNG, along with over 70 other natural gas companies, were served by Jack J. Grynberg, acting on behalf of the Government of the United States, with a Civil False Claims Act lawsuit alleging mismeasurement of the heating content and volume of natural gas resulting in underpayment of royalties to the federal government. The Company and the other named companies filed a motion to dismiss the lawsuit on grounds of improper joinder and lack of jurisdiction. The motion was granted in 1997, but the court gave Mr. Grynberg leave to refile this action in a court with proper jurisdiction. Mr. Grynberg appealed the dismissal of the action based on improper joinder, and the D.C. Court of Appeals affirmed the joinder decision in October 1998. Mr. Grynberg has filed a new case, modified somewhat from his original action, in Federal District Court, District of Colorado. The Company has not yet been served in this new action, which is under seal pending federal governmental reviews of the merits. The Department of Justice has not yet made a decision regarding whether to intervene in this new case. The Company has engaged in both formal and informal discussions with the Government regarding this case. The Company believes it has a meritorious position in this matter, and does not expect this lawsuit to have a material adverse effect on the Company's business, financial position or results of operations.
The Company believes it has meritorious defenses to all lawsuits and legal proceedings in which it is a defendant and will vigorously defend against them. Based on its evaluation of the above matters, and after consideration of reserves established, the Company believes that the resolution of such matters will not have a material adverse effect on the Company's business, financial position or results of operations.
5. PROPERTY, PLANT AND EQUIPMENT
Investments in property, plant and equipment, at cost, and accumulated depreciation and amortization ("Accumulated D&A"), detailed by business segment, are as follows:
*The increase in property, plant and equipment from December 31, 1997, to December 31, 1998, is largely due to the January 30, 1998, acquisition of MidCon and includes a gas plant acquisition adjustment (see Note 2).
6. INCOME TAXES
Deferred income tax assets and liabilities are recognized for temporary differences between the basis of assets and liabilities for financial reporting and tax purposes. Changes in tax legislation are included in the relevant computations in the period in which such changes are effective. Deferred tax assets are reduced by a valuation allowance for the amount of any tax benefit that is not expected to be realized.
Components of the income tax provision applicable to federal and state income taxes are as follows:
The difference between the statutory federal income tax rate and the Company's effective income tax rate is summarized as follows:
*Adjustments relate to the successful resolution of certain issues from prior years' income tax filings.
Deferred tax assets and liabilities result from the following:
7. FINANCING
(A) Notes Payable
On March 7, 1997, the Company's existing revolving credit agreement with seven commercial banks was amended to include a total of 11 banks and to increase the amount to $350 million (the "Pre-Acquisition Facility"). Effective with the acquisition of MidCon on January 30, 1998, the Pre-Acquisition Facility was replaced with a $4.5 billion credit facility (the "Bank Facility") consisting of (i) a $1.4 billion 364-day credit facility (the "L/C Facility") to support the note issued to Occidental in conjunction with the purchase of MidCon, (ii) a $2.1 billion, 364-day revolving facility (the "Acquisition Facility"), (iii) a $400 million five-year revolving credit facility (the "$400 million Facility") providing for loans and letters of credit, of which the letter of credit usage may not exceed $100 million and (iv) a 364-day $600 million revolving credit facility (the "$600 million Facility"). The L/C Facility and the Acquisition Facility could be used only in conjunction with the acquisition of MidCon. In addition to the working capital and acquisition components of the Bank Facility, K N assumed a short-term note for $1.4 billion payable to Occidental (the "Substitute Note"), which, pursuant to the Agreement, was initially collateralized by letters of credit issued under a commitment for that purpose within the Bank Facility.
The $2.1 billion Acquisition Facility was repaid in its entirety and cancelled on March 10, 1998. The Substitute Note was repaid on January 4, 1999. On January 5, 1999, K N cancelled the remaining letters of credit used to collateralize the Substitute Note. On January 8, 1999, the $600 million Facility was replaced with a new 364-day facility which is essentially the same as the previous agreement.
The bank facilities include covenants which are common in such arrangements, including requirements that (i) the ratio of the Company's total debt to total capitalization not exceed 74 percent initially (upon issuance of common stock to the holders of the premium equity participating security units ("PEPS") at the maturity thereof, the ratio will be reduced to 67 percent) and (ii) the Company's consolidated net worth (inclusive of trust preferred securities) be at least equal to the sum of $1.236 billion plus 50 percent of consolidated net income earned for each fiscal quarter ending after December 30, 1998.
Under the credit agreements described preceding, K N agreed to pay a facility fee based on the total commitment, at a rate which varies based on K N's senior debt rating. Facility fees paid in 1998 and 1997 were $1.7 million and $0.3 million, respectively. At December 31, 1998, there were no amounts outstanding under the Bank Facility as amended, compared with $100 million at December 31, 1997, under the Pre-Acquisition Facility.
Commercial paper issued by K N and supported by short-term credit facilities are unsecured short-term notes with maturities not to exceed 270 days from the date of issue. During 1998, all commercial paper was redeemed within 180 days, with interest rates ranging from 4.95 to 6.75 percent. Commercial paper outstanding at December 31, 1998 and 1997, respectively, was $297.0 million and $229.2 million. The weighted-average interest rates on short-term borrowings outstanding at December 31, 1998 and 1997, respectively, were 5.70 percent and 6.87 percent. Average short-term borrowings outstanding during 1998 and 1997 were $732.9 million and $212.6 million, respectively. During 1998 and 1997, the weighted-average interest rates on short-term borrowings outstanding were 5.91 percent (excluding the Substitute Note) and 5.74 percent, respectively.
(B) Long-Term Debt
Maturities of long-term debt for the five years ending December 31, 2003, are as follows:
In November 1998, the Company completed an underwritten public offering of $400 million of three-year senior notes (the "Senior Notes") bearing an interest rate of 6.45 percent. The net proceeds of approximately $397.4 million were used to retire a portion of K N's then-outstanding short-term borrowings. Concurrently with the
Senior Notes offering, the Company sold $460 million principal amount of PEPS in an underwritten public offering. The PEPS essentially are contracts (i) requiring the holders to purchase K N common stock at the end of a three-year period coinciding with the maturity of the Senior Notes and (ii) providing for payment of a contract fee of 2.375 percent to the PEPS holders by the Company during the three-year period. Payment of all or any part of the contract fees may be deferred by the Company until no later than the end of the three-year period and any portion so deferred will accrue interest at the annual rate of 8.25 percent until paid. The net cash proceeds from the sale of the PEPS, together with additional funds provided by the Company, were used to purchase U.S. treasury securities (the "Collateral") on behalf of the PEPS owners. The Collateral is the property of the PEPS holders and is pledged to the collateral agent, for the benefit of the Company, in support of the obligation of the PEPS holders to purchase K N common stock.
The face value of the PEPS is not recorded in the accompanying Consolidated Balance Sheets. The $29.4 million present value of the contract fee payable to the PEPS holders has been recorded as a liability and as a reduction to paid-in capital. During the period in which the contract fees are payable, accretion of the $3.4 million of discount initially recorded will increase the liability and further decrease paid-in capital. In addition, paid-in capital has been reduced for the issuance costs associated with the PEPS and the premium paid upon purchase of the Collateral, which amounts total approximately $32.8 million.
In March 1998, the Company received net proceeds of approximately $2.34 billion from the public offerings of senior debt securities of varying maturities with principal totaling $2.35 billion. The net proceeds from these offerings were used to refinance borrowings under the Bank Facility and to purchase U.S. government securities to replace a portion of the letters of credit that collateralized the Substitute Note.
Following are the principal amounts, maturity dates and coupon rates for the senior debt securities issued:
$500 million - 6.45% Senior Notes due March 1, 2003 $500 million - 6.65% Senior Notes due March 1, 2005 $300 million - 6.80% Senior Notes due March 1, 2008 $500 million - 7.25% Senior Debentures due March 1, 2028 $150 million - 7.45% Senior Debentures due March 1, 2098 $400 million - 6.30% Reset Put Securities due March 1, 2021
The 2003 Senior Notes and the 2005 Senior Notes are not redeemable prior to maturity. The 2008 Senior Notes, 2028 Senior Debentures and 2098 Senior Debentures are redeemable in whole or in part, at the option of the Company at any time, at redemption prices defined in the associated prospectus supplement. The Reset Put Securities due March 1, 2021 (the "2021 REPS") are subject to mandatory redemption from the then-existing holders on March 1, 2001, either (i) through the exercise of a call option by Morgan Stanley & Co. International Limited (the "Callholder") or (ii) in the event the Callholder does not exercise the call option, the automatic exercise of a mandatory put by First Trust National Association on behalf of the holders. The $12 million of proceeds received by K N from the Callholder as consideration for the call option are being amortized as an adjustment to the effective interest rate on the 2021 REPS. If the Callholder elects to exercise the call option, the interest rate will be reset at that time.
On October 27, 1997, the Company sold $150 million of 6.67% debentures maturing on November 1, 2027, in an underwritten public offering. These debentures are callable by the Company any time after November 1, 2004, and are redeemable at the option of the registered holders on November 1, 2004. The Company used the net proceeds from the sale to reduce outstanding short-term indebtedness.
At December 31, 1998 and 1997, the carrying amount of the Company's long-term debt was $3.3 billion and $585.5 million, respectively. The estimated fair values of the Company's long-term debt December 31, 1998 and 1997 are shown in Note 13.
(C) Capital Securities
In April 1998, the Company sold $175 million of 7.63% Capital Trust Securities maturing on April 15, 2028, in an underwritten public offering. The sale was effected through a wholly owned business trust, K N Capital Trust III. The Company used the net proceeds from the offering to purchase U.S. government securities to replace a portion of the letters of credit that collateralized the Substitute Note.
In April 1997, the Company sold $100 million of 8.56% Capital Trust Securities maturing on April 15, 2027, in an underwritten public offering. The sale was effected through a wholly owned business trust, K N Capital Trust I. The Company used the net proceeds from the sale to reduce outstanding short-term indebtedness.
The transactions and balances of K N Capital Trust I and K N Capital Trust III are included in the Company's consolidated financial statements, with the Capital Securities treated as a minority interest, shown in the Company's Consolidated Balance Sheets under the caption "K N-Obligated Mandatorily Redeemable Preferred Capital Trust Securities of Subsidiary Trust Holding Solely Debentures of K N." See Note 13 for the fair value of these securities.
(D) Common Stock
On November 9, 1998, the Board of Directors of K N Energy, Inc. approved a 7.1 percent increase in the quarterly dividend and a three-for-two split of the Company's common stock. The quarterly dividend was declared at $0.30 per common share, an increase from $0.28 per common share. Giving effect to the stock split, the quarterly dividend is $0.20 per common share. The stock split was distributed and the increase in dividend was paid concurrently on December 31, 1998, to shareholders of record at the close of business on December 15, 1998. The par value of the stock did not change. Weighted-average shares outstanding and all per share amounts in the accompanying consolidated financial statements and these notes have been restated to reflect the stock split.
In March 1998, the Company received net proceeds of approximately $624.6 million from a public offering of 12.5 million shares (18.75 million shares after adjustment for the December 1998 three-for-two stock split) of its common stock. The net proceeds from this offering were used to refinance borrowings under the Bank Facility and to purchase U.S. government securities to replace a portion of the letters of credit that collateralized the Substitute Note.
On June 11, 1997, Cabot exercised the remaining warrants held by it and purchased, in an unregistered offering, 642,232 shares (not adjusted for the December 1998 three-for-two stock split) of K N's common stock, which were issued to Cabot Specialty Chemicals, Inc., in exchange for Cabot's payment of $11.3 million.
8. PREFERRED STOCK
The Company has authorized 200,000 shares of Class A and 2,000,000 shares of Class B preferred stock, all without par value.
(A) Class A $5.00 Preferred Stock
At both December 31, 1998 and 1997, 70,000 shares of the Company's Class A $5.00 Cumulative Series preferred stock were outstanding. The Class A $5.00 Preferred Stock is redeemable, in whole or in part, at the option of the Company at any time on 30 days' notice at $105 per share plus accrued dividends and has no sinking fund requirements.
(B) Class B Preferred Stock
The Company did not have any outstanding shares of Class B Preferred Stock at December 31, 1998 or 1997. The remaining 5,720 shares of K N Class B $8.30 Preferred Stock subject to mandatory redemption were redeemed by the Company in 1996.
(C) Rights of Preferred Shareholders
All outstanding series of preferred stock have voting rights. If, for any class of preferred stock, the Company (i) is in arrears on dividends, (ii) has failed to pay or set aside any amounts required to be paid or set aside for all sinking funds or (iii) is in default on any of its redemption obligations, then no dividends shall be paid or declared on any class of stock junior to the preferred stock nor shall any of such stock be purchased or redeemed by the Company. Also, if dividends on any class of preferred stock are sufficiently in arrears, the holders of that stock may elect one-third of the Company's Board of Directors.
9. RISK MANAGEMENT
The Company uses two types of risk management instruments - energy financial instruments and interest rate swaps - as discussed following. The Company is exposed to credit-related losses in the event of nonperformance by counterparties to these financial instruments, but does not expect any counterparties to fail to meet their obligations given their existing credit ratings.
The fair value of these risk management instruments reflects the estimated amounts that the Company would receive or pay to terminate the contracts at the reporting date, thereby taking into account the current unrealized gains or losses on open contracts. Market quotes are available for substantially all financial instruments used by the Company.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (the "Statement"). The Statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. The Statement requires that changes in the derivatives fair value be recognized currently in earnings unless specific hedge accounting criteria are met. If the derivatives meet these criteria, the Statement allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company formally designate a derivative as a hedge and document and assess the effectiveness of derivatives associated with transactions that receive hedge accounting.
The Statement is effective for fiscal years beginning after June 15, 1999. A company may also implement the Statement as of the beginning of any fiscal quarter after issuance (that is, fiscal quarters beginning June 16, 1998 and thereafter). The Statement cannot be applied retroactively. The Statement must be applied to (i) derivative instruments and (ii) certain derivative instruments embedded in hybrid contracts that were issued, acquired, or substantively modified after December 31, 1997, (and, at the company's election, before January 1, 1998). K N
has not yet quantified the impacts of adopting the Statement on its financial position or results of operations and has not determined the timing of or method of adoption of the Statement.
In December 1998, the Emerging Issues Task Force ("EITF") issued EITF 98-10, Accounting for Energy Trading and Risk Management Activities. This consensus establishes accounting for energy trading activities prior to the adoption of the Statement. EITF 98-10 requires that energy contracts associated with trading activities be recorded at fair value on the balance sheet, with the changes in fair value included in earnings. The effects of initial application of EITF 98-10 are required to be reported as a cumulative effect of a change in accounting principle. Financial statements for periods prior to initial adoption of EITF 98-10 may not be restated. EITF 98-10 is effective for fiscal years beginning after December 15, 1998. Given the Company's restrictive policy with respect to the use of energy derivatives as discussed following, the Company does not expect any material impact from the application of EITF 98-10 to its operations.
(A) Energy Financial Instruments
The Company uses energy financial instruments to reduce its risk of price changes in the spot and fixed price natural gas and NGLs markets. Energy risk management products include commodity futures and options contracts, fixed-price swaps and basis swaps. Pursuant to its Board of Directors' approved policy, the Company is to engage in these activities only as a hedging mechanism against price volatility associated with pre-existing or anticipated physical gas and condensate sales, gas purchases, system use and storage in order to protect profit margins, and is prohibited from engaging in speculative trading. Commodity-related activities of the risk management group are monitored by the Company's Risk Management Committee, which is charged with the review and enforcement of the Board of Directors' risk management policy. Changes in fair value for trading activities are recognized currently in earnings within the caption "Other, Net" under the heading "Other Income and (Deductions)" in the Consolidated Statements of Income. All energy futures, swaps and options are recorded at fair value. Gains and losses on hedging positions are deferred and recognized as gas purchases expense in the periods which the underlying physical transactions occur.
Purchases of commodity contracts and over-the-counter swaps and options require 75 percent of the contract amount to be placed in margin accounts. At December 31, 1998, the Company had $9.1 million in such margin accounts, which amounts are shown as "Restricted Deposits" in the accompanying Consolidated Balance Sheets.
The differences between the current market value and the original physical contracts' value, associated with hedging activities, are reflected, depending on maturity, as deferred charges or credits and other current assets or liabilities in the accompanying Consolidated Balance Sheets. These deferrals are offset by the corresponding value of the underlying physical transactions. In the event energy financial instruments do not meet the criteria for hedge accounting, the deferred gains or losses associated with the corresponding financial instruments would be included in the results of operations in the current period. In the event energy financial instruments are terminated prior to the period of physical delivery of the items being hedged, the gains or losses on the energy financial instruments at the time of termination remain deferred until the period of physical delivery unless both the energy financial instruments and the items being hedged result in a loss. If this occurs, the loss is recorded immediately.
Following is selected information concerning the Company's risk management activities:
Deferred net losses are reflected in "Deferred Charges and Other Assets" in the accompanying Consolidated Balance Sheets and will be matched with the corresponding underlying physical transactions.
(B) Interest Rate Swaps
From time to time, the Company has entered into various interest rate swap and cap agreements for the purpose of managing interest rate exposure, none of which agreements is leveraged. Settlement amounts payable or receivable under these agreements is recorded as interest expense or income in the accounting period they are incurred. The notional principal covered under such arrangements for the periods presented are not material to the consolidated financial statements.
10. EMPLOYEE BENEFITS
(A) Retirement Plans
The Company has defined benefit pension plans covering substantially all full-time employees. These plans provide pension benefits that are based on the employees' compensation during the period of employment, age and years of service. These plans are tax-qualified subject to the minimum funding requirements of the Employee Retirement Income Security Act of 1974. The Company's funding policy is to contribute annually the recommended contribution using the actuarial cost method and assumptions used for determining annual funding requirements.
In February 1998, the Financial Accounting Standards Board issued SFAS No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits. This statement revises employers' disclosures about pension and other postretirement benefit plans and requires additional information on changes in the benefit obligations and fair values of plan assets. Restatement of disclosures for earlier periods provided for comparative purposes is required.
Plan assets consist primarily of pooled fixed income, equity, bond and money market funds. Plan assets include securities of the Company valued at $5.0 million as of December 31, 1998.
Net periodic pension cost includes the following components:
The following table sets forth the reconciliation of the beginning and ending balances of the pension benefit obligation:
The following table sets forth the reconciliation of the beginning and ending balances of the fair value of the plans' assets, the plans' funded status and amounts recognized under the caption "Other Current Assets" in the Company's Consolidated Balance Sheets:
The rate of increase in future compensation and the expected long-term rate of return on plan assets were 3.5 percent and 8.5 percent, respectively, for both 1998 and 1997. The weighted-average discount rate used in determining the actuarial present value of the projected benefit obligation was 6.75 percent and 7.25 percent for 1998 and 1997, respectively.
The Company makes discretionary annual contributions to the K N Energy, Inc. Profit Sharing and Savings Plan (the "Profit Sharing Plan"), a defined contribution plan. Contributions are made in the year following the year for which the contribution amount is calculated. The Company's contribution amount is determined by comparing actual results for that year to a predetermined graduated scale of annual operating goals. No contribution was made to the Profit Sharing Plan for 1998. For 1997 and 1996, the Company contributed amounts equal to seven percent and the ten percent maximum of eligible employee compensation, respectively. The 1997 and 1996 contributions were $5.3 million and $6.6 million, respectively, 50 percent of which was in the form of Company stock.
In January 1998, the Company acquired the MidCon Retirement Plan ("MRA") as part of its acquisition of MidCon (see Note 2 (D)). The MRA is a defined contribution plan. Contributions to the plan are based on age and earnings. Effective January 1, 1999, the MRA was merged into the Profit Sharing Plan, at which time eligible MidCon employees joined the Company's defined benefit pension plans. In 1998, the Company contributed $4.6 million to the MRA.
(B) Other Postretirement Employee Benefits
The Company has a defined benefit postretirement plan providing medical and life insurance benefits upon retirement for eligible employees and their eligible dependents, including former MidCon employees who met the eligibility requirements on the date of acquisition of MidCon (see note 2 (D)). The Company acquired the postretirement medical and life insurance plans of already retired employees of MidCon as a result of the acquisition of MidCon. These plans were "grandfathered" in by the Company as of the acquisition date and no new employees have or will be added to these plans subsequent to the acquisition date. The Company funds the future expected postretirement benefit cost under the plan by making payments to Voluntary Employee Benefit Association trusts. The Company's funding policy is to contribute amounts within the deductibility limits imposed on Internal Revenue Code Sec. 501(c)(9) trusts. Plan assets consist primarily of pooled fixed income funds.
Net periodic postretirement benefit cost includes the following components:
The following table sets forth the reconciliation of the beginning and ending balances of the accumulated postretirement benefit obligation ("APBO"):
The following table sets forth the reconciliation of the beginning and ending balances of the fair value of plan assets, the plan's funded status and the amounts included under the caption "Other" in the category "Other Liabilities and Deferred Credits" in the Company's Consolidated Balance Sheets:
* Represents activity during the year indicated.
The weighted-average discount rate used in determining the actuarial present value of the APBO was 6.75 percent in 1998 and 7.25 percent in 1997. The assumed health care cost trend rate was 7 percent for 1998 and beyond. A one-percentage-point increase (decrease) in the assumed health care cost trend rate for each future year would have increased (decreased) the aggregate of the service and interest cost components of the 1998 net periodic postretirement benefit cost by approximately $24,000 ($26,000) and would have increased (decreased) the APBO as of December 31, 1998, by approximately $249,000 ($251,000).
11. COMMON STOCK OPTION AND PURCHASE PLANS
The Company has the following stock option plans: The 1982 Incentive Stock Option Plan (the "1982 Plan"), the 1982 Stock Option Plan for Non-Employee Directors (the "1982 Directors' Plan"), the 1986 Incentive Stock Option Plan (the "1986 Plan"), the 1988 Incentive Stock Option Plan (the "1988 Plan"), the 1992 Stock Option Plan for Non-Employee Directors (the "1992 Directors' Plan"), the 1994 K N Energy, Inc. Long-Term Incentive Plan (the "LTIP Plan") and the American Oil and Gas Corporation Stock Incentive Plan (the "AOG Plan"). The Company also has an employee stock purchase plan (the "ESP Plan"). All per share amounts and shares outstanding or exercisable presented in this note have been restated to reflect the impact of the December 31, 1998, three-for-two common stock split as discussed in Note 7 (D).
The Company accounts for its plans under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. The Company recorded compensation expense totaling $3.1 million, $2.4 million and $0.8 million for 1998, 1997 and 1996, respectively, relating to restricted stock grants awarded under the plans.
Had compensation cost for these plans been determined consistent with SFAS No. 123, Accounting for Stock-Based Compensation ("SFAS 123"), the Company's net income and diluted earnings per share would have been reduced to the following pro forma amounts:
Because the SFAS 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years. Additionally, the pro forma amounts include $0.6 million, $0.4 million and $0.4 million related to the purchase discount offered under the ESP Plan for 1998, 1997 and 1996, respectively.
The Company may sell up to 2,400,000 shares of stock to its eligible employees under the ESP Plan. Employees purchased 163,799 shares, 132,202 shares and 131,422 shares for plan years 1998, 1997 and 1996, respectively, and have purchased 1,022,900 shares from inception through the 1998 plan year. Shares are issued in the month following the end of each plan year. Employees purchase shares through voluntary payroll deductions at a 15 percent discount from the market value of the common stock, as defined in the plan. The weighted-average fair value per share of purchase rights granted in 1998, 1997 and 1996 was $5.94, $6.48 and $4.30, respectively.
Under all plans, except the LTIP Plan and the AOG Plan, options are granted at not less than 100 percent of the market value of the stock at the date of grant. Under the LTIP Plan options may be granted at less than 100 percent of the market value of the stock at the date of grant. Certain restricted stock awards include provisions accelerating the lapsing of restrictions in the event certain operating goals are met.
At December 31, 1998, 236 employees, officers and directors of the Company held options under the plans. A summary of the status of the Company's stock option plans at December 31, 1998, 1997 and 1996, and changes during the years then ended is presented in the table and narrative below:
The following table sets forth K N's December 31, 1998, common stock options outstanding, weighted-average exercise prices, weighted-average remaining contractual lives, common stock options exercisable and the exercisable weighted-average exercise price:
The weighted-average fair value of each option grant is estimated on the date of grant using the Black Scholes option pricing model with the following assumptions: risk-free interest rate of 5.5 percent, expected weighted-average lives of 4 years and expected volatility of .25 for grants in 1998, and .20 for grants in 1997 and 1996; and expected dividend yields of 3.5 percent for grants in 1998, and 2.5 percent for grants in 1997 and 1996.
12. COMMITMENTS AND CONTINGENT LIABILITIES
(A) Leases
The Company has entered into a number of operating leases, including those referred to in Note 2.
Expenses incurred under operating leases were $61.2 million in 1998, $33.0 million in 1997 and $22.3 million in 1996. Future minimum commitments under major operating leases as of December 31, 1998, are as follows:
Certain of the Company's operating lease arrangements provide that, in the event that the rating of K N's senior debt is lowered below investment grade by both of the two major rating agencies, the Company would be required to post letters of credit in support of its remaining lease payments. Although the Company currently has no information to indicate that such downgrades will occur, given the Company's current level of borrowing and utilization of its letter of credit facility, the posting of these additional letters of credit in support of lease obligations would place the Company in default under the terms of its revolving credit facility. The Company currently believes that, should such a default occur, it could obtain a waiver of the applicable default provisions or modification of such provisions to allow the facility to remain in place, although the pricing would likely increase.
(B) Guarantees of Unconsolidated Subsidiaries' Debt
The Company has executed various guarantees of unconsolidated subsidiaries' revolving credit agreements as follows:
(C) Capital Expenditures Budget
The consolidated capital expenditures budget for 1999 totals $160 million. Approximately $44.3 million had been committed for the purchase of plant and equipment at December 31, 1998.
13. FAIR VALUE
The following fair values of Investments, Long-Term Debt, Capital Securities and K N Preferred Stock were estimated based on an evaluation made by an independent securities analyst. Fair values of "Energy Financial Instruments, Net" reflect the estimated amounts that the Company would receive or pay to terminate the contracts at the reporting date, thereby taking into account the current unrealized gains or losses on open contracts. Market quotes are available for substantially all instruments used by the Company.
(i) Fair values for TBI Class A Preferred Stock are not readily available.
14. BUSINESS SEGMENT INFORMATION
K N Energy, Inc. has adopted a strategy of extracting profit from the energy value stream which extends from the purchase or production of the fuel through the sale of the energy to the end-user. Consistent with this strategy, K N manages its business and has segregated its activities into three business segments, "Upstream," "Midstream" and "Downstream," based on where in the value stream such activities are conducted. In general, these segments are also differentiated by the nature of their processes, their principal suppliers and their target markets and customers. The Company's Upstream operations consist of natural gas gathering, natural gas processing, and NGLs extraction and marketing; Midstream operations consist of transportation, storage and bundled sales transactions for K N's interstate and intrastate pipelines; Downstream operations principally consist of energy marketing, regulated natural gas distribution and electric power generation and sales.
The accounting policies applied in the generation of segment information are generally the same as those described in Note 1 except that, in general, items below the "Operating Income" line are either not allocated to business segments or are not considered by Management in its evaluation of business unit performance. In addition, certain items included in operating income (such as the merger-related costs incurred in 1998) are not allocated to individual business segments. With adjustment for these items, the Company currently evaluates business segment performance primarily based on operating income in relation to the level of capital employed. In general, intersegment sales are accounted for at market prices, while asset transfers are made at either market value or, in some instances, book value. For comparative purposes, prior period results and balances have been reclassified to conform to the current presentation.
\
BUSINESS SEGMENT INFORMATION (Before Intersegment Eliminations)
(1) Represents costs related to the MidCon Acquisition (see Note 2). (2) Balances at December 31 for the year indicated. (3) Other assets represent principally cash, restricted deposits and U.S. government securities.
GEOGRAPHIC INFORMATION
All but an insignificant amount of the Company's assets and operations are located in the continental United States.
QUARTERLY FINANCIAL INFORMATION (UNAUDITED) K N ENERGY, INC. AND SUBSIDIARIES
QUARTERLY OPERATING RESULTS FOR 1998 AND 1997
PART III
ITEM 10:
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
(A) Identification of Directors
For information regarding the Directors, see the 1999 Proxy Statement.
(B) Identification of Executive Officers
See Executive Officers of the Registrant under Part I.
(C) Identification of Certain Significant Employees
None.
(D) Family Relationships
See "Election of Directors" Section of the 1999 Proxy Statement.
(E) Business Experience
See Executive Officers of the Registrant under Part I. For business experience of the Directors, see the 1999 Proxy Statement.
(F) Involvement in Certain Legal Proceedings
None.
(G) Promoters and Control Persons
None.
ITEM 11:
ITEM 11: EXECUTIVE COMPENSATION
See "Director Compensation," "Report of the Compensation Committee on Executive Compensation," "Executive Compensation," "Stock Options," "Performance Graph," "Pension and Supplemental Benefits" and "Severance and Other Agreements" Sections in the 1999 Proxy Statement.
ITEM 12:
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
See the 1999 Proxy Statement Sections: (i) relating to common stock owned by directors; (ii) "Executive Stock Ownership;" and (iii) "Principal Shareholders."
ITEM 13:
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
(A) Transactions with Management and Others
See "Relationship Between Certain Directors and the Company" section in the 1999 Proxy Statement.
(B) Certain Business Relationships
See "Relationship Between Certain Directors and the Company" section in the 1999 Proxy Statement.
(C) Indebtedness of Management
See "Relationship Between Certain Directors and the Company" section in the 1999 Proxy Statement.
(D) Transactions with Promoters
Not applicable.
PART IV
ITEM 14:
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) See the index for a listing and page numbers of financial statements and exhibits included herein or incorporated by reference.
K N ENERGY, INC. AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
Executive Compensation Plans and Arrangements
Form of Key Employee Severance Agreement (Exhibit 10.2, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)*
1982 Stock Option Plan for Nonemployee Directors of the Company with Form of Grant Certificate (Exhibit 10.3, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)*
1982 Incentive Stock Option Plan for key employees of the Company (Exhibit 10.4, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)*
1986 Incentive Stock Option Plan for key employees of the Company (Exhibit 10.5, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)*
1988 Incentive Stock Option Plan for key employees of the Company (Exhibit 10.6, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)*
Form of Grant Certificate for Employee Stock Option Plans (Exhibit 10.7, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)*
Directors' Deferred Compensation Plan Agreement (Exhibit 10.8, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)*
1987 Directors' Deferred Fee Plan As Amended and Form of Participation Agreement regarding the Plan (Exhibit 10(h) to the Annual Report on Form 10-K for the year ended December 31, 1995)*
1992 Stock Option Plan for Nonemployee Directors of the Company with Form of Grant Certificate (Exhibit 4.1, File No. 33-46999)*
1994 K N Energy, Inc. Long-Term Incentive Plan (Attachment A to the K N Energy, Inc. 1994 Proxy Statement on Schedule 14-A)*
K N Energy, Inc. 1996 Executive Incentive Plan (Exhibit 10(l) to the Annual Report on Form 10-K for the year ended December 31, 1995)*
K N Energy, Inc. Nonqualified Deferred Compensation Plan (Exhibit 10(m) to the Annual Report on Form 10-K for the year ended December 31, 1994)*
K N Energy, Inc. Nonqualified Retirement Income Restoration Plan (Exhibit 10(n) to the Annual Report on Form 10-K for the year ended December 31, 1994)*
K N Energy, Inc. Nonqualified Profit Sharing Restoration Plan (Exhibit 10(o) to the Annual Report on Form 10-K for the year ended December 31, 1994)*
Employment Agreement dated December 14, 1995 between K N Energy, Inc. and Morton C. Aaronson (Exhibit 10(p) to the Annual Report on Form 10-K for the year ended December 31, 1995)*
Letter Agreement dated December 4, 1995 between K N Energy, Inc. and Charles W. Battey (Exhibit 10(q) to the Annual Report on Form 10-K for the year ended December 31, 1995)*
K N Energy, Inc. Performance Incentive Plan (Exhibit 10(u) to the Annual Report on Form 10-K for the year ended December 31, 1995)*
Form of Change of Control Severance Agreement (Exhibit 10(u) to the Annual Report on Form 10-K for the year ended December 31, 1996)*
Form of Incentive Stock Option Agreement (Exhibit 10(v) to the Annual Report on Form 10-K for the year ended December 31, 1996)*
Form of Restricted Stock Agreement (Exhibit 10(w) to the Annual Report on Form 10-K for the year ended December 31, 1996)*
Employment Agreement dated March 21, 1996 between K N Energy, Inc. and Murray R. Smith (Exhibit 10(x) to the Annual Report on Form 10-K for the year ended December 31, 1996)*
Directors and Executives Deferred Compensation Plan effective January 1, 1998 for executive officers and directors of the Company (Attached hereto as Exhibit 10(aa).
Management Deferred Compensation Plan effective January 1, 1998 for senior management of the Company (Attached hereto as Exhibit 10(bb).
(b) Reports on Form 8-K
On October 7, 1998, a Current Report on Form 8-K/A was filed to present an unaudited pro forma consolidated income statement for K N Energy, Inc. and MidCon Corp. for the six months ended June 30, 1998 and related notes.
On October 9, 1998, a Current Report on Form 8-K was filed to present selected historical segment information for the Company.
On November 24, 1998, a Current Report on Form 8-K was filed to report the issuance on or about November 25, 1998, of 10,706,000 of the Company's 8.25% Premium Equity Participating Security Units.
* Incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
K N ENERGY, INC. (Registrant) Date: March 9, 1999 By /s/ Clyde E. McKenzie ----------------------------- Clyde E. McKenzie Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
Exhibit Index
Exhibit Index
Exhibit Index
Exhibit Index
* Incorporated herein by reference. ** Included in SEC and NYSE copies only. *** Such report is being furnished for the information of the Securities and Exchange Commission only and is not to be deemed filed as a part of this annual report on Form 10-K. **** Included in SEC copy only.